Quarterly Report



UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


FORM 10-Q

 


 

x

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

For the Quarterly Period Ended September 30, 2013

OR

 

¨

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

For the Transition Period From                  to                 

Commission File Number: 0-14278

 


MICROSOFT CORPORATION

(Exact name of registrant as specified in its charter)

 


 

Washington   91-1144442

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

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

(425) 882-8080

(Registrant’s telephone number, including area code)

None

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

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

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

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

 

Large accelerated filer  x

  

Accelerated filer  ¨

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

  

Smaller reporting company  ¨

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

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

 

Class    Outstanding at October 16, 2013  


Common Stock, $0.00000625 par value per share

     8,347,968,348 shares   

 



MICROSOFT CORPORATION

FORM 10-Q

For the Quarter Ended September 30, 2013

INDEX

 

                 Page  

PART I.

  FINANCIAL INFORMATION        
    Item 1.   Financial Statements        
        a)    Income Statements for the Three Months Ended September 30, 2013 and 2012     3   
        b)    Comprehensive Income Statements for the Three Months Ended September 30, 2013 and 2012     4   
        c)    Balance Sheets as of September 30, 2013 and June 30, 2013     5   
        d)    Cash Flows Statements for the Three Months Ended September 30, 2013 and 2012     6   
        e)    Stockholders’ Equity Statements for the Three Months Ended September 30, 2013 and 2012     7   
        f)    Notes to Financial Statements     8   
        g)    Report of Independent Registered Public Accounting Firm     29   
    Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations     30   
    Item 3.   Quantitative and Qualitative Disclosures About Market Risk     46   
    Item 4.   Controls and Procedures     47   

PART II.  

  OTHER INFORMATION        
    Item 1.   Legal Proceedings     47   
    Item 1A.   Risk Factors     48   
    Item 2.   Unregistered Sales of Equity Securities and Use of Proceeds     55   
    Item 6.   Exhibits     56   

SIGNATURES

    57   

 

2


PART I

Item 1

 

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

INCOME STATEMENTS

 

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


Three Months Ended September 30,    2013     2012  

Revenue

   $   18,529      $   16,008   

Cost of revenue

     5,114        4,168   


 


Gross margin

     13,415        11,840   

Operating expenses:

                

Research and development

     2,767        2,460   

Sales and marketing

     3,304        2,945   

General and administrative

     1,010        1,127   


 


Total operating expenses

     7,081        6,532   


 


Operating income

     6,334        5,308   

Other income

     74        226   


 


Income before income taxes

     6,408        5,534   

Provision for income taxes

     1,164        1,068   


 


Net income

   $ 5,244      $ 4,466   
    


 


Earnings per share:

                

Basic

   $ 0.63      $ 0.53   

Diluted

   $ 0.62      $ 0.53   

Weighted average shares outstanding:

                

Basic

     8,339        8,396   

Diluted

     8,434        8,494   

Cash dividends declared per common share

   $ 0.28      $ 0.23   


See accompanying notes.

 

3


PART I

Item 1

 

COMPREHENSIVE INCOME STATEMENTS

 

(In millions) (Unaudited)             


Three Months Ended September 30,    2013     2012  

Net income

   $   5,244      $   4,466   

Other comprehensive income (loss):

                

Net unrealized losses on derivatives (net of tax effects of $(3) and $(24))

     (26     (45

Net unrealized gains on investments (net of tax effects of $492 and $148)

     952        274   

Translation adjustments and other (net of tax effects of $33 and $91)

     62        169   


 


Other comprehensive income

     988        398   


 


Comprehensive income

   $ 6,232      $ 4,864   
    


 


See accompanying notes.

 

4


PART I

Item 1

 

BALANCE SHEETS

 

(In millions) (Unaudited)             


September 30,

2013

    June 30,
2013
 

Assets

                

Current assets:

                

Cash and cash equivalents

   $ 4,023      $ 3,804   

Short-term investments (including securities loaned of $484 and $579)

     76,649        73,218   


 


Total cash, cash equivalents, and short-term investments

     80,672        77,022   

Accounts receivable, net of allowance for doubtful accounts of $294 and $336

     11,007        17,486   

Inventories

     2,613        1,938   

Deferred income taxes

     1,258        1,632   

Other

     3,900        3,388   


 


Total current assets

     99,450        101,466   

Property and equipment, net of accumulated depreciation of $13,038 and $12,513

     10,774        9,991   

Equity and other investments

     11,995        10,844   

Goodwill

     14,667        14,655   

Intangible assets, net

     2,982        3,083   

Other long-term assets

     2,480        2,392   


 


Total assets

   $   142,348      $   142,431   
    


 


Liabilities and stockholders’ equity

                

Current liabilities:

                

Accounts payable

   $ 4,841      $ 4,828   

Short-term debt

     1,300        0   

Current portion of long-term debt

     2,000        2,999   

Accrued compensation

     2,856        4,117   

Income taxes

     834        592   

Short-term unearned revenue

     18,585        20,639   

Securities lending payable

     582        645   

Other

     3,625        3,597   


 


Total current liabilities

     34,623        37,417   

Long-term debt

     12,632        12,601   

Long-term unearned revenue

     1,629        1,760   

Deferred income taxes

     2,236        1,709   

Other long-term liabilities

     9,587        10,000   


 


Total liabilities

     60,707        63,487   


 


Commitments and contingencies

                

Stockholders’ equity:

                

Common stock and paid-in capital—shares authorized 24,000; outstanding 8,346 and 8,328

     67,230        67,306   

Retained earnings

     11,680        9,895   

Accumulated other comprehensive income

     2,731        1,743   


 


Total stockholders’ equity

     81,641        78,944   


 


Total liabilities and stockholders’ equity

   $ 142,348      $ 142,431   
    


 


See accompanying notes.

 

5


PART I

Item 1

 

CASH FLOWS STATEMENTS

 

(In millions) (Unaudited)             


Three Months Ended September 30,    2013     2012  

Operations

                

Net income

   $ 5,244      $ 4,466   

Adjustments to reconcile net income to net cash from operations:

                

Depreciation, amortization, and other

     954        710   

Stock-based compensation expense

     635        603   

Net recognized losses on investments and derivatives

     93        11   

Excess tax benefits from stock-based compensation

     (205     (177

Deferred income taxes

     404        38   

Deferral of unearned revenue

     7,436        8,209   

Recognition of unearned revenue

     (9,677     (8,770

Changes in operating assets and liabilities:

                

Accounts receivable

     6,617        6,156   

Inventories

     (667     (473

Other current assets

     (556     (385

Other long-term assets

     (81     (233

Accounts payable

     (276     (567

Other current liabilities

     (1,255     (1,287

Other long-term liabilities

     (461 )     183   


 


Net cash from operations

     8,205        8,484   


 


Financing

                

Short-term borrowings, maturities less than 90 days, net

     712        0   

Proceeds from issuance of debt

     588        0   

Repayments of debt

     (1,000     0   

Common stock issued

     203        417   

Common stock repurchased

     (2,188     (1,632

Common stock cash dividends paid

     (1,916     (1,676

Excess tax benefits from stock-based compensation

     205        177   


 


Net cash used in financing

     (3,396     (2,714


 


Investing

                

Additions to property and equipment

     (1,231     (603

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

     (15     (1,145

Purchases of investments

       (14,768       (20,138

Maturities of investments

     347        1,259   

Sales of investments

     11,117        13,307   

Securities lending payable

     (64     (399


 


Net cash used in investing

     (4,614     (7,719


 


Effect of exchange rates on cash and cash equivalents

     24        47   


 


Net change in cash and cash equivalents

     219        (1,902

Cash and cash equivalents, beginning of period

     3,804        6,938   


 


Cash and cash equivalents, end of period

   $ 4,023      $ 5,036   
    


 


See accompanying notes.

 

6


PART I

Item 1

 

STOCKHOLDERS’ EQUITY STATEMENTS

 

(In millions) (Unaudited)             


Three Months Ended September 30,    2013     2012  

Common stock and paid-in capital

                

Balance, beginning of period

   $   67,306      $   65,797   

Common stock issued

     203        406   

Common stock repurchased

     (1,121     (891

Stock-based compensation expense

     635        603   

Stock-based compensation income tax benefits

     205        167   

Other, net

     2        2   


 


Balance, end of period

     67,230        66,084   


 


Retained earnings (deficit)

                

Balance, beginning of period

     9,895        (856

Net income

     5,244        4,466   

Common stock cash dividends

     (2,337     (1,937

Common stock repurchased

     (1,122     (741


 


Balance, end of period

     11,680        932   


 


Accumulated other comprehensive income

                

Balance, beginning of period

     1,743        1,422   

Other comprehensive income

     988        398   


 


Balance, end of period

     2,731        1,820   


 


Total stockholders’ equity

   $ 81,641      $ 68,836   
    


 


See accompanying notes.

 

7


PART I

Item 1

 

NOTES TO FINANCIAL STATEMENTS

(Unaudited)

NOTE 1 — ACCOUNTING POLICIES

Accounting Principles

In the opinion of management, the accompanying balance sheets and related interim statements of income, comprehensive income, cash flows, and stockholders’ equity include all adjustments, consisting only of normal recurring items, necessary for their fair presentation in conformity with accounting principles generally accepted in the United States of America (“U.S. GAAP”). Interim results are not necessarily indicative of results for a full year. The information included in this Form 10-Q should be read in conjunction with information included in the Microsoft Corporation 2013 Form 10-K filed on July 30, 2013 with the U.S. Securities and Exchange Commission.

Principles of Consolidation

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

Estimates and Assumptions

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

Recasting of Certain Prior Period Information

During the first quarter of fiscal year 2014, we changed our organizational structure as part of our transformation to a devices and services company. As a result of these changes, information that our chief operating decision maker regularly reviews for purposes of allocating resources and assessing performance changed. Therefore, beginning in fiscal year 2014, we are reporting our financial performance based on our new segments described in Note 16 – Segment Information. We have recast certain prior period amounts to conform to the way we internally manage and monitor segment performance during the current fiscal year. This change impacted Note 8 – Goodwill, Note 12 – Unearned Revenue, and Note 16 – Segment Information, with no impact on consolidated net income or cash flows.

Recent Accounting Guidance

Recently adopted accounting guidance

In December 2011, the Financial Accounting Standards Board (“FASB”) issued guidance enhancing disclosure requirements about the nature of an entity’s right to offset and related arrangements associated with its financial instruments. The new guidance requires the disclosure of the gross amounts subject to rights of set-off, amounts offset in accordance with the accounting standards followed, and the related net exposure. In January 2013, the FASB clarified that the scope of this guidance applies to derivatives, repurchase agreements, and securities lending arrangements that are either offset or subject to an enforceable master netting arrangement, or similar agreements. We adopted this new guidance beginning July 1, 2013. Adoption of this new guidance resulted only in changes to the presentation of Note 5 – Derivatives.

In February 2013, the FASB issued guidance on disclosure requirements for items reclassified out of accumulated other comprehensive income (“AOCI”). This new guidance requires entities to present (either on the face of the income

 

8


PART I

Item 1

 

statement or in the notes) the effects on the line items of the income statement for amounts reclassified out of AOCI. We adopted this new guidance beginning July 1, 2013. Adoption of this new guidance resulted only in changes to the presentation of Note 15 – Accumulated Other Comprehensive Income.

Recent accounting guidance not yet adopted

In March 2013, the 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. The new guidance will be effective for us beginning July 1, 2014. We do not anticipate material impacts on our financial statements upon adoption.

NOTE 2 — EARNINGS PER SHARE

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

The components of basic and diluted EPS are as follows:

 

(In millions, except earnings per share)             


Three Months Ended September 30,    2013     2012  

Net income available for common shareholders (A)

   $   5,244      $   4,466   

Weighted average outstanding shares of common stock (B)

     8,339        8,396   

Dilutive effect of stock-based awards

     95        98   


 


Common stock and common stock equivalents (C)

     8,434        8,494   
    


 


Earnings Per Share             

Basic (A/B)

   $ 0.63      $ 0.53   

Diluted (A/C)

   $ 0.62      $ 0.53   


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

NOTE 3 — OTHER INCOME (EXPENSE)

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

 

(In millions)             


Three Months Ended September 30,    2013     2012  

Dividends and interest income

   $ 179      $   159   

Interest expense

       (118     (95

Net recognized losses on investments

     (7     (15

Net gains (losses) on derivatives

     (86     4   

Net gains (losses) on foreign currency remeasurements

     26        (29

Other

     80        202   


 


Total

   $ 74      $ 226   
    


 


 

9


PART I

Item 1

 

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

 

(In millions)             


Three Months Ended September 30,    2013     2012  

Other-than-temporary impairments of investments

   $ (36   $ (90

Realized gains from sales of available-for-sale securities

       114          101   

Realized losses from sales of available-for-sale securities

     (85     (26


 


Total

   $ (7   $ (15
    


 


NOTE 4 — INVESTMENTS

Investment Components

The components of investments, including associated derivatives, were as follows:

 

(In millions)    Cost Basis    

Unrealized

Gains

   

Unrealized

Losses

   

Recorded

Basis

   

Cash

and Cash

Equivalents

   

Short-term

Investments

   

Equity

and Other

Investments

 


September 30, 2013                                           

Cash

   $ 2,489      $ 0      $ 0      $ 2,489      $ 2,489      $ 0      $ 0   

Mutual funds

     700        0        0        700        700        0        0   

Commercial paper

     816        0        0        816        262        554        0   

Certificates of deposit

     683        0        0        683        442        241        0   

U.S. government and agency securities

     65,981        101        (61     66,021        130        65,891        0   

Foreign government bonds

     1,080        18        (30     1,068        0        1,068        0   

Mortgage-backed securities

     1,149        40        (10     1,179        0        1,179        0   

Corporate notes and bonds

     7,160        211        (33     7,338        0        7,338        0   

Municipal securities

     345        28        (2 )     371        0        371        0   

Common and preferred stock

     6,768        4,111        (140     10,739        0        0        10,739   

Other investments

     1,263        0        0        1,263        0        7        1,256   


 


 


 


 


 


 


Total

   $   88,434      $     4,509      $       (276   $   92,667      $     4,023      $   76,649      $   11,995   
    


 


 


 


 


 


 


 

(In millions)    Cost Basis     Unrealized
Gains
    Unrealized
Losses
    Recorded
Basis
    Cash
and Cash
Equivalents
    Short-term
Investments
    Equity
and Other
Investments
 


June 30, 2013                                           

Cash

   $ 1,967      $ 0      $ 0      $ 1,967      $ 1,967      $ 0      $ 0   

Mutual funds

     868        0        0        868        868        0        0   

Commercial paper

     603        0        0        603        214        389        0   

Certificates of deposit

     994        0        0        994        609        385        0   

U.S. government and agency securities

     64,934        47        (84     64,897        146        64,751        0   

Foreign government bonds

     900        16        (41     875        0        875        0   

Mortgage-backed securities

     1,258        43        (13     1,288        0        1,288        0   

Corporate notes and bonds

     4,993        169        (40     5,122        0        5,122        0   

Municipal securities

     350        36        (1     385        0        385        0   

Common and preferred stock

     6,931        2,938        (281     9,588        0        0        9,588   

Other investments

     1,279        0        0        1,279        0        23        1,256   


 


 


 


 


 


 


Total

   $   85,077      $     3,249      $       (460   $   87,866      $     3,804      $   73,218      $   10,844   
    


 


 


 


 


 


 


 

10


PART I

Item 1

 

Unrealized Losses on Investments

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

 

     Less than 12 Months     12 Months or Greater          

Total

Unrealized

Losses

 
    


 


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


September 30, 2013                                     

U.S. government and agency securities

   $ 1,386      $ (53   $ 242      $ (8 )   $ 1,628      $ (61

Foreign government bonds

     870        (29     3        (1     873        (30

Mortgage-backed securities

     298        (9 )     55        (1     353        (10

Corporate notes and bonds

     944        (29     95        (4     1,039        (33

Municipal securities

     49        (2     0        0        49        (2

Common and preferred stock

     921        (129     72        (11     993        (140


 


 


 


 


 


Total

   $   4,468      $     (251   $       467      $       (25   $   4,935      $     (276
    


 


 


 


 


 


 

     Less than 12 Months     12 Months or Greater           Total
Unrealized
Losses
 
    


 


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


June 30, 2013                                     

U.S. government and agency securities

   $ 2,208      $ (84   $ 0      $ 0      $ 2,208      $ (84

Foreign government bonds

     589        (18     69        (23     658        (41

Mortgage-backed securities

     357        (12     39        (1     396        (13

Corporate notes and bonds

     1,142        (38     27        (2     1,169        (40

Municipal securities

     44        (1     0        0        44        (1

Common and preferred stock

     1,166        (168     409        (113     1,575        (281


 


 


 


 


 


Total

   $   5,506      $    (321   $       544      $     (139   $   6,050      $     (460
    


 


 


 


 


 


Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Unrealized losses from domestic and international equities are due to market price movements. Management does not believe any remaining unrealized losses represent other-than-temporary impairments based on our evaluation of available evidence as of September 30, 2013.

As of September 30, 2013 and June 30, 2013, the recorded bases of common and preferred stock and other investments that are restricted for more than one year or are not publicly traded were $416 million and $395 million, respectively. These investments are carried at cost and are reviewed quarterly for indicators of other-than-temporary impairment. It is not practicable for us to reliably estimate the fair value of these investments.

Debt Investment Maturities

 

(In millions)    Cost Basis    

Estimated

Fair Value

 


September 30, 2013             

Due in one year or less

   $   25,824      $   25,852   

Due after one year through five years

     44,904        45,042   

Due after five years through 10 years

     4,702        4,753   

Due after 10 years

     1,784        1,829   


 


Total

   $ 77,214      $ 77,476   
    


 


 

11


PART I

Item 1

 

NOTE 5 — DERIVATIVES

We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; to enhance investment returns; and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Our derivative programs include strategies that both qualify and do not qualify for hedge accounting treatment. All notional amounts presented below are measured in U.S. dollar equivalents.

Foreign Currency

Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency hedge positions. Option and forward contracts are used to hedge a portion of forecasted international revenue for up to three years in the future and are designated as cash-flow hedging instruments. Principal currencies hedged include the euro, Japanese yen, British pound, and Canadian dollar. As of September 30, 2013 and June 30, 2013, the total notional amounts of these foreign exchange contracts sold were $5.0 billion and $5.1 billion, respectively.

Foreign currency risks related to certain non-U.S. dollar denominated securities are hedged using foreign exchange forward contracts that are designated as fair-value hedging instruments. As of September 30, 2013 and June 30, 2013, the total notional amounts of these foreign exchange contracts sold were $343 million and $407 million, respectively.

Certain options and forwards not designated as hedging instruments are also used to manage the variability in exchange rates on accounts receivable, cash, and intercompany positions, and to manage other foreign currency exposures. As of September 30, 2013, the total notional amounts of these foreign exchange contracts purchased and sold were $4.9 billion and $5.5 billion, respectively. As of June 30, 2013, the total notional amounts of these foreign exchange contracts purchased and sold were $5.0 billion and $7.9 billion, respectively.

Equity

Securities held in our equity and other investments portfolio are subject to market price risk. Market price risk is managed relative to broad-based global and domestic equity indices using certain convertible preferred investments, options, futures, and swap contracts not designated as hedging instruments. From time to time, to hedge our price risk, we may use and designate equity derivatives as hedging instruments, including puts, calls, swaps, and forwards. As of September 30, 2013, the total notional amounts of equity contracts purchased and sold for managing market price risk were $1.4 billion and $1.2 billion, respectively and none of which were designated as hedging instruments. As of June 30, 2013, the total notional amounts of equity contracts purchased and sold for managing market price risk were $898 million and $1.0 billion, respectively, none of which were designated as hedging instruments.

In connection with our agreement to purchase substantially all of the Devices & Services business of Nokia Corporation (“Nokia”), on September 23, 2013 we provided to Nokia 1.5 billion ($2.0 billion) of financing in the form of convertible notes, which we have recorded as short-term investments. See further discussion in Note 13 – Contingencies. The total notional amount of derivatives related to the Nokia convertible notes was $2.0 billion as of September 30, 2013. See Note 6 – Fair Value Measurements for additional details.

Interest Rate

Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of our fixed-income portfolio to achieve economic returns that correlate to certain broad-based fixed-income indices using exchange-traded option and futures contracts and over-the-counter swap and option contracts, none of which are designated as hedging instruments. As of September 30, 2013, the total notional amounts of fixed-interest rate contracts purchased and sold were $1.0 billion and $585 million, respectively. As of June 30, 2013, the total notional amounts of fixed-interest rate contracts purchased and sold were $1.1 billion and $809 million, respectively.

In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency mortgage-backed securities. These meet the definition of a derivative instrument in cases where physical delivery of the assets is not taken at the earliest available delivery date. As of September 30, 2013 and June 30, 2013, the total notional derivative amounts of mortgage contracts purchased were $1.0 billion and $1.2 billion, respectively.

 

12


PART I

Item 1

 

Credit

Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts, not designated as hedging instruments, to manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. We use credit default swaps as they are a low-cost method of managing exposure to individual credit risks or groups of credit risks. As of September 30, 2013, the total notional amounts of credit contracts purchased and sold were $423 million and $497 million, respectively. As of June 30, 2013, the total notional amounts of credit contracts purchased and sold were $377 million and $501 million, respectively.

Commodity

We use broad-based commodity exposures to enhance portfolio returns and to facilitate portfolio diversification. We use swaps, futures, and option contracts, not designated as hedging instruments, to generate and manage exposures to broad-based commodity indices. We use derivatives on commodities as they can be low-cost alternatives to the purchase and storage of a variety of commodities, including, but not limited to, precious metals, energy, and grain. As of September 30, 2013, the total notional amounts of commodity contracts purchased and sold were $1.4 billion and $231 million, respectively. As of June 30, 2013, the total notional amounts of commodity contracts purchased and sold were $1.2 billion and $249 million, respectively.

Credit-Risk-Related Contingent Features

Certain of our counterparty agreements for derivative instruments contain provisions that require our issued and outstanding long-term unsecured debt to maintain an investment grade credit rating and require us to maintain minimum liquidity of $1.0 billion. To the extent we fail to meet these requirements, we will be required to post collateral, similar to the standard convention related to over-the-counter derivatives. As of September 30, 2013, our long-term unsecured debt rating was AAA, and cash investments were in excess of $1.0 billion. As a result, no collateral was required to be posted.

Fair Values of Derivative Instruments

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

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

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

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

 

13


PART I

Item 1

 

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

 

          September 30, 2013           June 30, 2013  
   


 


          Assets     Liabilities           Assets     Liabilities  
   


 


 


 


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

Other

Current
Liabilities

 


Non-designated Hedge Derivatives                                                

Foreign exchange contracts

           $     27      $     68      $     (68            $     41      $     87      $     (63

Equity contracts

            202              0        (9             157        0        (9

Interest rate contracts

            15        0        (11             18        0        (45

Credit contracts

            20        0        (17             19        0        (17

Commodity contracts

            5        0        (3             3        0        (1


 


 


         


 


 


Total

          $   269      $     68      $   (108           $   238      $     87      $   (135
           


 


 


         


 


 


Designated Hedge Derivatives                                                

Foreign exchange contracts

          $       0      $     66      $       (7           $       9      $   167      $        0   


 


 


         


 


 


Total

          $       0      $     66      $       (7           $       9      $   167      $        0   


 


 


         


 


 


Total gross amounts of derivatives

          $   269      $   134      $   (115           $   247      $   254      $   (135
           


 


 


         


 


 


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

          $   126      $   134      $   (115           $   105      $   254      $     (97

Gross amount offset in the balance sheet

            (73     (24     97                (72     (9     80   


 


 


         


 


 


Net amounts presented in the balance sheet

          $     53      $   110      $     (18           $     33      $   245      $     (17

Gross amounts not offset in the balance sheet

            0        0        0                0        0        0   


 


 


         


 


 


Net amount

          $     53      $   110      $     (18           $     33      $   245      $     (17
           


 


 


         


 


 


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

Fair-Value Hedge Gains (Losses)

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

 

(In millions)             


Three Months Ended September 30,    2013     2012  
Foreign Exchange Contracts             

Derivatives

   $   (14   $   (12

Hedged items

     13        14   


 


Total

   $ (1 )   $ 2   
    


 


 

14


PART I

Item 1

 

Cash Flow Hedge Gains (Losses)

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

 

(In millions)             


Three Months Ended September 30,    2013     2012  
Effective Portion             

Losses recognized in OCI (net of tax effect of $(2) and $(12))

   $ (8   $ (23

Gains reclassified from AOCI into revenue

   $ 19      $ 35   
Amount Excluded from Effectiveness Assessment and Ineffective Portion             

Losses recognized in other income (expense)

   $   (80   $   (71


We estimate that $51 million of net derivative gains included in AOCI at September 30, 2013 will be reclassified into earnings within the following 12 months. No significant amounts of gains (losses) were reclassified from AOCI into earnings as a result of forecasted transactions that failed to occur during the three months ended September 30, 2013.

Non-Designated Derivative Gains (Losses)

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

 

(In millions)             


Three Months Ended September 30,    2013     2012  

Foreign exchange contracts

   $ 14      $   (13

Equity contracts

     (5 )     2   

Interest-rate contracts

     13        18   

Credit contracts

     (1     (7

Commodity contracts

     11        66   


 


Total

   $   32      $ 66   
    


 


NOTE 6 — FAIR VALUE MEASUREMENTS

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

 

   

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

 

   

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

 

15


PART I

Item 1

 

   

Level 3 —inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability. The fair values are therefore determined using model-based techniques, including option pricing models and discounted cash flow models. Our Level 3 non-derivative assets primarily comprise investments in certain corporate bonds and goodwill when it is recorded at fair value due to an impairment charge. We value the Level 3 corporate bonds using internally developed valuation models, inputs to which include interest rate curves, credit spreads, stock prices, volatilities, and probability-weighted scenarios. Unobservable inputs used in all of these models are significant to the fair values of the assets and liabilities.

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

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

Assets and Liabilities Measured at Fair Value on a Recurring Basis

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

 

(In millions)

     Level 1        Level 2        Level 3 (a)      

 

Gross Fair

Value

  

  

    Netting (b)      
 
Net Fair
Value
  
  


September 30, 2013                                     
Assets                                     

Mutual funds

   $ 700      $ 0      $ 0      $ 700      $ 0      $ 700   

Commercial paper

     0        816        0        816        0        816   

Certificates of deposit

     0        683        0        683        0        683   

U.S. government and agency securities

     63,306        2,717        0        66,023        0        66,023   

Foreign government bonds

     9        1,067        0        1,076        0        1,076   

Mortgage-backed securities

     0        1,178        0        1,178        0        1,178   

Corporate notes and bonds

     0        5,079        2,048        7,127        0        7,127   

Municipal securities

     0        371        0        371        0        371   

Common and preferred stock

     8,930        1,381        12        10,323        0        10,323   

Derivatives

     6        368        29        403        (97     306   


 


 


 


 


 


Total

   $   72,951      $   13,660      $   2,089      $   88,700      $   (97   $   88,603   
    


 


 


 


 


 


Liabilities                                     

Derivatives and other

   $ 8      $ 107      $ 0      $ 115      $ (97   $ 18   


 

16


PART I

Item 1

 

(In millions)

     Level 1        Level 2        Level 3       

 

Gross Fair

Value

  

  

    Netting (b)      
 
Net Fair
Value
  
  


June 30, 2013                                     
Assets                                     

Mutual funds

   $ 868      $ 0      $ 0      $ 868      $ 0      $ 868   

Commercial paper

     0        603        0        603        0        603   

Certificates of deposit

     0        994        0        994        0        994   

U.S. government and agency securities

     62,237        2,664        0        64,901        0        64,901   

Foreign government bonds

     9        851        0        860        0        860   

Mortgage-backed securities

     0        1,311        0        1,311        0        1,311   

Corporate notes and bonds

     0        4,915        19        4,934        0        4,934   

Municipal securities

     0        385        0        385        0        385   

Common and preferred stock

     8,470        717        5        9,192        0        9,192   

Derivatives

     12        489        0        501        (81     420   


 


 


 


 


 


Total

   $   71,596      $   12,929      $   24      $   84,549      $   (81   $   84,468   
    


 


 


 


 


 


Liabilities                                     

Derivatives and other

   $ 14      $ 121      $ 0      $ 135      $ (80   $ 55   


 

(a)

Level 3 assets at September 30, 2013 primarily comprised €1.5 billion principal amount of Nokia convertible notes. The valuation of these notes considers the probability of the acquisition transaction closing as well as an analysis of market comparable transactions and management assumptions. The probability-weighted scenarios are considered significant unobservable inputs used in the fair value measurement of both the convertible notes and the embedded derivative. Significant changes in these probabilities in isolation would significantly alter the fair value measurement for both the notes and the embedded derivative.

 

(b)

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

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

 

(In millions)             


September 30,

2013

    June 30,
2013
 

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

   $   88,603      $   84,468   

Cash

     2,489        1,967   

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

     416        395   

Other investments measured at fair value on a nonrecurring basis

     1,256        1,256   

Less derivative assets classified as other current assets

     (93     (213

Other

     (4     (7


 


Recorded basis of investment components

   $ 92,667      $ 87,866   
    


 


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

During the three months ended September 30, 2013 and 2012, we did not record any material other-than-temporary impairments on financial assets required to be measured at fair value on a nonrecurring basis.

 

17


PART I

Item 1

 

NOTE 7 — INVENTORIES

The components of inventories were as follows:

 

(In millions)             


September 30,

2013

   

June 30,

2013

 

Raw materials

   $ 673      $ 328   

Work in process

     166        201   

Finished goods

     1,774        1,409   


 


Total

   $   2,613      $   1,938   
    


 


NOTE 8 — GOODWILL

Changes in the carrying amount of goodwill were as follows:

 

(In millions)        

June 30,

2013

    Acquisitions     Other     September 30,
2013
 


Devices and Consumer            

   Licensing    $ 866                 $    0      $ 1                 $       867   
    

Hardware

     1,689                0        (9             1,680   
    

Other

     738                0        0                738   


         


 


         


    

Total Devices and Consumer

   $ 3,293                $    0      $ (8             $    3,285   

Commercial

   Licensing    $ 10,051                $    0      $ 20                $  10,071   
    

Other

     1,311                0        0                1,311   


         


 


         


    

Total Commercial

   $ 11,362                $    0      $ 20                11,382   


         


 


         


Total goodwill

        $   14,655                $    0      $   12                $  14,667   
         


         


 


         


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

Any change in the goodwill amounts resulting from foreign currency translations and business dispositions are presented as “Other” in the above table.

As discussed in Note 16 – Segment Information, during the first quarter of fiscal year 2014, we changed our organizational structure as part of our transformation to a devices and services company. This resulted in a change in our operating segments and reporting units. We allocated goodwill to our new reporting units using a relative fair value approach. In addition, we completed an assessment of any potential goodwill impairment for all reporting units immediately prior to the reallocation and determined that no impairment existed.

 

18


PART I

Item 1

 

NOTE 9 — INTANGIBLE ASSETS

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

 

(In millions)    Gross
Carrying
Amount
    Accumulated
Amortization
   

Net

Carrying
Amount

    Gross
Carrying
Amount
    Accumulated
Amortization
   

Net

Carrying
Amount

 


      

 

September 30,

2013

  

  

   

 

June 30,

2013

  

  

Technology-based  (a)

   $ 3,749      $ (2,160   $ 1,589      $ 3,760      $ (2,110   $ 1,650   

Marketing-related

     1,347        (232     1,115        1,348        (211     1,137   

Contract-based

     812        (683     129        823        (688     135   

Customer-related

     373        (224     149        380        (219     161   


 


 


 


 


 


Total

   $   6,281      $   (3,299   $   2,982      $   6,311      $   (3,228   $   3,083   
    


 


 


 


 


 


 

(a)

Technology-based intangible assets included $208 million and $218 million as of September 30, 2013 and June 30, 2013, respectively, of net carrying amount of software to be sold, leased, or otherwise marketed.

Intangible assets amortization expense was $162 million and $178 million for the three months ended September 30, 2013 and 2012, respectively. Amortization of capitalized software was $46 million and $40 million for the three months ended September 30, 2013 and 2012, respectively.

The following table outlines the estimated future amortization expense related to intangible assets held at September 30, 2013:

 

(In millions)       


Year Ending June 30,       

2014 (excluding the three months ended September 30, 2013)

   $ 493   

2015

     479   

2016

     390   

2017

     287   

2018

     246   

Thereafter

     1,087   


Total

   $   2,982   
    


NOTE 10 — DEBT

As of September 30, 2013, we had $15.9 billion of issued and outstanding debt, comprising $1.3 billion of commercial paper and $14.6 billion of long-term debt, including the current portion.

Short-term Debt

As of September 30, 2013, we had $1.3 billion of commercial paper issued and outstanding, with a weighted-average interest rate of 0.10% and maturities of 70 to 98 days. The estimated fair value of this commercial paper approximates its carrying value.

In June 2013, we entered into a $1.3 billion credit facility, which serves as a back-up for our commercial paper. As of September 30, 2013, 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. The credit facility expires on June 24, 2018. No amounts were drawn against the credit facility since its inception.

 

19


PART I

Item 1

 

Long-term Debt

As of September 30, 2013, the total carrying value and estimated fair value of our long-term debt, including the current portion, were $14.6 billion and $14.5 billion, respectively. This is compared to a carrying value and estimated fair value of $15.6 billion and $15.8 billion, respectively, as of June 30, 2013. These estimated fair values are based on Level 2 inputs.

The components of our long-term debt, including the current portion, and the associated interest rates were as follows as of September 30, 2013 and June 30, 2013:

 

Due Date  

Face Value

September 30,

2013

   

Face Value

June 30,
2013

   

Stated
Interest

Rate

    

Effective
Interest

Rate

 


          (In millions)               
Notes                               

September 27, 2013

           $            0      $ 1,000        0.875%         1.000%   

June 1, 2014

            2,000        2,000        2.950%         3.049%   

September 25, 2015

            1,750        1,750        1.625%         1.795%   

February 8, 2016

            750        750        2.500%         2.642%   

November 15, 2017

            600        600        0.875%         1.084%   

May 1, 2018

            450        450        1.000%         1.106%   

June 1, 2019

            1,000        1,000        4.200%         4.379%   

October 1, 2020

            1,000        1,000        3.000%         3.137%   

February 8, 2021

            500        500        4.000%         4.082%   

November 15, 2022

            750        750        2.125%         2.239%   

May 1, 2023

            1,000        1,000        2.375%         2.465%   

May 2, 2033  (a)

            745        715        2.625%         2.690%   

June 1, 2039

            750        750        5.200%         5.240%   

October 1, 2040

            1,000        1,000        4.500%         4.567%   

February 8, 2041

            1,000        1,000        5.300%         5.361%   

November 15, 2042

            900        900        3.500%         3.571%   

May 1, 2043

            500        500        3.750%         3.829%   


                

Total

          $   14,695      $   15,665                    
           


 


                

 

(a)

In April 2013, we issued €550 million of debt securities.

The notes are senior unsecured obligations and rank equally with our other unsecured and unsubordinated debt outstanding. Interest on the notes is paid semi-annually, except for the euro-denominated debt securities on which interest is paid annually. As of September 30, 2013 and June 30, 2013, the aggregate unamortized discount for our long-term debt, including the current portion, was $63 million and $65 million, respectively.

NOTE 11 — INCOME TAXES

Our effective tax rates were approximately 18% and 19% for the three months ended September 30, 2013 and 2012, respectively. Our effective tax rate was lower than the U.S. federal statutory rate primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico.

Tax contingencies and other tax liabilities were $9.0 billion and $9.4 billion as of September 30, 2013 and June 30, 2013, respectively, and were included in other long-term liabilities. While we settled a portion of the I.R.S. audit for tax years 2004 to 2006 during the third quarter of fiscal year 2011, we remain under audit for these 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, 2013, the primary unresolved issue related to transfer pricing which could have a significant impact on our financial statements if not resolved favorably. We believe our allowances for tax contingencies are appropriate. We do not believe it is reasonably possible that the total amount of unrecognized tax benefits will significantly increase or decrease within the next 12 months, as we do not believe the remaining open issues will be resolved within the next 12 months. We also continue to be subject to examination by the I.R.S. for tax years 2007 to 2012.

 

20


PART I

Item 1

 

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 2012, some of which are currently under audit by local tax authorities. The resolutions of these audits are not expected to be material to our financial statements.

NOTE 12 — UNEARNED REVENUE

Unearned revenue by segment was as follows, with segments with significant balances shown separately:

 

(In millions)             


September 30,

2013

  

  

   

 

June 30,

2013

  

  

Commercial Licensing

   $ 16,270      $ 18,460   

Commercial Other

     1,989        2,272   

Rest of the segments

     1,955        1,667   


 


Total

   $   20,214      $   22,399   
    


 


NOTE 13 — CONTINGENCIES

Antitrust, Unfair Competition, and Overcharge Class Actions

A large number of antitrust and unfair competition class action lawsuits were filed against us in various state, federal, and Canadian courts on behalf of various classes of direct and indirect purchasers of our PC operating system and certain other software products between 1999 and 2005. We obtained dismissals or reached settlements of all claims made in the United States.

Under the settlements, generally class members can obtain vouchers that entitle them to be reimbursed for purchases of a wide variety of platform-neutral computer hardware and software. The total value of vouchers that we may issue varies by state. We will make available to certain schools a percentage of those vouchers that are not issued or claimed (one-half to two-thirds depending on the state). The total value of vouchers we ultimately issue will depend on the number of class members who make claims and are issued vouchers. We estimate the total remaining cost to resolve all of the state overcharge class action cases is approximately $500 million.

Three cases pending in British Columbia, Ontario, and Quebec, Canada have not been settled. In March 2010, the court in the British Columbia case certified it as a class action. In April 2011, the British Columbia Court of Appeal reversed the class certification ruling and dismissed the case, holding that indirect purchasers do not have a claim. The plaintiffs have filed an appeal to the Canadian Supreme Court, which was heard in the fall of 2012. The other two actions have been stayed.

Other Antitrust Litigation and Claims

In November 2004, Novell, Inc. (“Novell”) filed a complaint in U.S. District Court for the District of Utah (later transferred to federal court in Maryland), asserting antitrust and unfair competition claims against us related to Novell’s ownership of WordPerfect and other productivity applications during the period between June 1994 and March 1996. After the trial court dismissed or granted summary judgment on a number of Novell’s claims, trial of the one remaining claim took place from October to December 2011, and resulted in a mistrial. In July 2012, the trial court granted Microsoft’s motion for judgment as a matter of law. Novell appealed this decision to the U.S. Court of Appeals for the Tenth Circuit, which affirmed the trial court’s decision in September 2013.

Patent and Intellectual Property Claims

Motorola litigation

In October 2010, Microsoft filed patent infringement complaints against Motorola Mobility (“Motorola”) with the International Trade Commission (“ITC”) and in U.S. District Court in Seattle for infringement of nine Microsoft patents by Motorola’s Android devices. Since then, Microsoft and Motorola have filed additional claims against each other in the ITC, in federal district courts in Seattle, Wisconsin, Florida, and California, and in courts in Germany and the United Kingdom. The nature of the claims asserted and status of individual matters are summarized below.

 

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PART I

Item 1

 

International Trade Commission

In May 2012, the ITC issued a limited exclusion order against Motorola on one Microsoft patent, which order became effective on July 18, 2012. Microsoft appealed certain aspects of the ITC rulings adverse to Microsoft, and Motorola has appealed the ITC exclusion order, to the Court of Appeals for the Federal Circuit. In October 2013, the U.S. Court of Appeals for the Federal Circuit ruled in Microsoft’s favor on one additional patent and remanded the proceedings on that patent back to the ITC. Motorola’s appeal remains pending.

In July 2013, Microsoft filed an action in U.S. district court in Washington, D.C. seeking an order to compel enforcement of the ITC’s May 2012 import ban against infringing Motorola products by the Bureau of Customs and Border Protection (“CBP”), after learning that CBP had failed to fully enforce the order.

In November 2010, Motorola filed an action against Microsoft in the ITC alleging infringement of five Motorola patents by Xbox consoles and accessories and seeking an exclusion order to prohibit importation of the allegedly infringing Xbox products into the U.S. At Motorola’s request, the ITC terminated its investigation as to four Motorola patents, leaving only one Motorola patent at issue. In March 2013, the ALJ ruled that there has been no violation of the remaining Motorola patent. Motorola sought ITC review of the ALJ’s determination, which the ITC denied in May 2013. Motorola has appealed the ITC’s decision to the U.S. Court of Appeals for the Federal Circuit.

U.S. District Court

The Seattle District Court case filed in October 2010 by Microsoft as a companion to Microsoft’s ITC case against Motorola has been stayed pending the outcome of Microsoft’s ITC case.

In November 2010, Microsoft sued Motorola for breach of contract in U.S. District Court in Seattle, alleging that Motorola breached its commitments to standards-setting organizations to license to Microsoft certain patents on reasonable and non-discriminatory (“RAND”) terms and conditions. Motorola has declared these patents essential to the implementation of the H.264 video standard and the 802.11 Wi-Fi standard. In the Motorola ITC case described above and in suits described below, Motorola or a Motorola affiliate subsequently sued Microsoft on those patents in U.S. District Courts, in the ITC, and in Germany. In February 2012, the Seattle District Court granted a partial summary judgment in favor of Microsoft ruling that (1) Motorola entered into binding contractual commitments with standards organizations committing to license its declared-essential patents on RAND terms and conditions; and (2) Microsoft is a third-party beneficiary of those commitments. After trial, the Seattle District Court set per unit royalties for Motorola’s H.264 and 802.11 patents, which resulted in an immaterial Microsoft liability. In September 2013, following trial of Microsoft’s breach of contract claim, a jury awarded $14.5 million in damages to Microsoft. Motorola is expected to appeal.

Cases filed by Motorola in Wisconsin, California, and Florida, with the exception of one currently stayed case in Wisconsin (a companion case to Motorola’s ITC action), have been transferred to the U.S District Court in Seattle. Motorola and Microsoft both seek damages as well as injunctive relief. No trial dates have been set in any of the transferred cases, and the court has stayed these cases on agreement of the parties.

 

   

In the transferred cases, Motorola asserts 15 patents are infringed by many Microsoft products including Windows Mobile 6.5 and Windows Phone 7, Windows Marketplace, Silverlight, Windows Vista and Windows 7, Exchange Server 2003 and later, Exchange ActiveSync, Windows Live Messenger, Lync Server 2010, Outlook 2010, Office 365, SQL Server, Internet Explorer 9, Xbox, and Kinect.

 

   

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

 

   

In counterclaims in the patent actions brought by Motorola, Microsoft asserts 14 patents are infringed by Motorola Android devices and certain Motorola digital video recorders.

Germany

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

 

   

Two patents (one now expired) are asserted by Motorola to be essential to implementation of the H.264 video standard, and Motorola alleges that H.264 capable products including Xbox 360, Windows 7, Media Player, and Internet Explorer infringe those patents. In May 2012, the court issued an injunction relating to all H.264 capable Microsoft products in Germany. However, due to orders in the separate litigation pending in Seattle, Washington described above, Motorola is enjoined from taking steps to enforce the German injunction. Damages would be determined in later proceedings. Microsoft has appealed the rulings of the first instance court.

 

22


PART I

Item 1

 

   

Motorola asserts that one patent covers certain syncing functionality in the ActiveSync protocol employed by Windows Phone 7, Outlook Mobile, Hotmail Mobile, Exchange Online, Exchange Server, and Hotmail Server. In April 2013, the court stayed the case pending the outcome of parallel proceedings in which Microsoft is seeking to invalidate the patent.

 

   

Microsoft may be able to mitigate the adverse impact of any injunction issued and enforced by altering its products to avoid Motorola’s infringement claims.

 

   

Any damages would be determined in separate proceedings.

In lawsuits Microsoft filed in Germany in 2011 and 2012, Microsoft asserts Motorola Android devices infringe Microsoft patents and is seeking damages and injunctions. In 2012, regional courts in Germany issued injunctions on three of the patents Microsoft asserts. Motorola appealed each of the cases to the regional appellate court where one judgment has been affirmed and the other two are still pending. One of Microsoft’s cases is still pending in the regional court. Microsoft is taking steps to enforce the injunctions and ensure compliance. Damages will be determined in later proceedings. Microsoft has pending appeals on two of the four cases it lost in the regional court. Separately, Motorola has filed nullity actions in the German Federal Patent Court to have Microsoft’s patents declared invalid. For the cases in which Microsoft is enforcing injunctions, if Motorola were to prevail on its appeal of the infringement judgment or its nullity action, Motorola could have a claim against Microsoft for damages caused by an erroneously granted injunction.

United Kingdom

In December 2011, Microsoft filed an action against Motorola in the High Court of Justice, Chancery Division, Patents Court, in London, England, seeking to revoke the UK part of the European patent asserted by Motorola in Germany against the ActiveSync protocol. In February 2012, Motorola counterclaimed alleging infringement of the patent and seeking damages and an injunction. A trial took place in December 2012, and the court ruled that Motorola’s patent is invalid and revoked. The court also ruled that the patent, even if valid, would be licensed under the grant-back clause in Google’s ActiveSync license. Motorola has appealed.

Other patent and intellectual property claims

In addition to these cases, there are approximately 70 other patent infringement cases pending against Microsoft.

Other

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

As of September 30, 2013, we had accrued aggregate liabilities of $301 million in other current liabilities and $167 million in other long-term liabilities for all of our legal matters that were contingencies as of that date. While we intend to defend these matters vigorously, adverse outcomes that we estimate could reach approximately $200 million in aggregate beyond recorded amounts are reasonably possible. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse impact on our financial statements for the period in which the effects become reasonably estimable.

Other Commitments

On September 2, 2013, we announced that we entered into a definitive agreement to acquire substantially all of Nokia’s Devices & Services business, license Nokia’s patents, and license and use Nokia’s mapping services. Under the terms of the agreement, we agreed to pay 3.79 billion (approximately $5.0 billion) to purchase substantially all of Nokia’s Devices & Services business, and 1.65 billion (approximately $2.2 billion) to license Nokia’s patents, for a total transaction price of 5.44 billion (approximately $7.2 billion) in cash. We intend to draw upon our overseas cash resources to fund the acquisition. In connection with this agreement, on September 23, 2013 we provided Nokia 1.5 billion ($2.0 billion) of financing in the form of convertible notes, which are included in short-term investments on our balance sheet. Nokia will repay these notes from the proceeds of the acquisition upon closing. We expect the acquisition will close in the first calendar quarter of 2014, subject to approval by Nokia’s shareholders, regulatory approvals, and other closing conditions.

 

23


PART I

Item 1

 

In February 2013, we announced that we agreed to lend $2.0 billion to the group that has proposed to take Dell private upon the closing of their merger transaction. On September 12, 2013, Dell announced shareholder approval of the merger transaction.

NOTE 14 — STOCKHOLDERS’ EQUITY

Share Repurchases

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

 

(In millions)             


Three Months Ended September 30,

     2013        2012   

Shares of common stock repurchased

     47        33   

Value of common stock repurchased

   $   1,500      $   1,000   


Excluded from this table are shares repurchased to settle statutory employee tax withholding related to the vesting of stock awards. We repurchased all shares with cash resources. On September 16, 2013, our Board of Directors approved a $40.0 billion share repurchase program, which replaced the share repurchase program that expired September 30, 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.

Dividends

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

 

Declaration Date   

Dividend

Per Share

    Record Date      Total Amount     Payment Date  


                  (in millions)        

September 16, 2013

   $   0.28        November 21, 2013       $   2,337        December 12, 2013   

September 18, 2012

   $   0.23        November 15, 2012       $   1,933        December 13, 2012   


The dividend declared on September 16, 2013 was included in other current liabilities as of September 30, 2013.

 

24


PART I

Item 1

 

NOTE 15 — ACCUMULATED OTHER COMPREHENSIVE INCOME

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

 

(In millions)       


Three Months Ended September 30,    2013     2012  
Derivatives             

Accumulated other comprehensive income balance, beginning of period

   $ 66      $ 92   

Unrealized losses, net of tax effects of $(2) and $(11)

     (8     (23

Reclassification adjustments for gains included in revenue

     (19     (35

Tax expense included in provision for income taxes

     1        13   


 


Amounts reclassified from accumulated other comprehensive income

     (18     (22


 


Net current period other comprehensive loss

     (26     (45


 


Accumulated other comprehensive income balance, end of period

   $ 40      $ 47   


 


Investments             

Accumulated other comprehensive income balance, beginning of period

   $ 1,794      $ 1,431   

Unrealized gains, net of tax effects of $490 and $143

     947        264   

Reclassification adjustments for losses included in other income (expense)

     7        15   

Tax benefit included in provision for income taxes

     (2     (5


 


Amounts reclassified from accumulated other comprehensive income

     5        10   


 


Net current period other comprehensive income

     952        274   


 


Accumulated other comprehensive income balance, end of period

   $ 2,746      $ 1,705   


 


Translation adjustments and other             

Accumulated other comprehensive loss balance, beginning of period

   $ (117   $ (101

Translation adjustments and other, net of tax effects of $33 and $91

     62        169   


 


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

   $ (55   $ 68   


 


Accumulated other comprehensive income, end of period

   $   2,731      $   1,820   
    


 


NOTE 16 — SEGMENT INFORMATION

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

During the first quarter of fiscal year 2014, we changed our organizational structure as part of our transformation to a devices and services company. As a result of these changes, information that our chief operating decision maker regularly reviews for purposes of allocating resources and assessing performance changed. Therefore, beginning in fiscal year 2014, we are reporting our financial performance based on our new segments; Devices and Consumer (“D&C”) Licensing, D&C Hardware, D&C Other, Commercial Licensing, and Commercial Other. We have recast certain prior period amounts to conform to the way we internally manage and monitor segment performance during the current fiscal year. Our reportable segments are described below.

Devices and Consumer

Our D&C segments develop and market 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 original equipment manufacturer (“OEM”) licensing (“Windows OEM”) and other non-volume licensing and academic volume licensing of the Windows operating

 

25


PART I

Item 1

 

 

system and related software (collectively, “Consumer Windows”); non-volume licensing of Microsoft Office, comprising the core Office product set, for consumers (“Consumer Office”); Windows Phone, including related patent licensing; and certain other patent licensing revenue;

 

   

D&C Hardware , comprising: the Xbox 360 gaming and entertainment console and accessories, second-party and third-party video games, and Xbox LIVE subscriptions (“Xbox Platform”); Surface; and Microsoft PC accessories; and

 

   

D&C Other , comprising: Resale, including Windows Store, Xbox LIVE transactions, and the Windows Phone Marketplace; search advertising; display advertising; Subscription, comprising Office 365 (“O365”) Home Premium; Studios, comprising first-party video games; our retail stores; and certain other consumer products and services not included in the categories above.

Commercial

Our Commercial segments develop and market software and services designed to increase individual, team, and organization productivity and efficiency, and to simplify 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, and System Center; Windows Embedded; volume licensing of the Windows operating system, excluding academic (“Commercial Windows”); Microsoft Office for business, including Office, Exchange, SharePoint, and Lync (“Commercial Office”); Client Access Licenses, which provide access rights to certain server products (“CAL”); Microsoft Dynamics business solutions, excluding Dynamics CRM Online; and Skype; and

 

   

Commercial Other , comprising: Enterprise Services, including Premier product support services and Microsoft Consulting Services; Cloud Services, comprising O365, excluding O365 Home Premium (“Commercial O365”), other Microsoft Office online offerings, Dynamics CRM Online, and Windows Azure; and certain other commercial products and online services not included in the categories above.

Revenue and cost of revenue are generally directly attributed to our segments. Certain revenue contracts are allocated among the segments based on the relative value of the underlying products and services. Cost of revenue is directly charged to the D&C Hardware segment. For the remaining segments, cost of revenue is directly charged in most cases and allocated in certain cases, generally using a relative revenue methodology.

We do not allocate operating expenses to our segments. Rather, we allocate them to our two segment groups, Devices and Consumer and Commercial. Due to the integrated structure of our business, allocations of expenses are made in certain cases to incent cross-collaboration among our segment groups so that a segment group is not solely burdened by the cost of a mutually beneficial activity as we seek to deliver seamless experiences across devices, whether on premise or in the cloud.

Operating expenses are attributed to our segment groups as follows:

 

   

Sales and marketing expenses are primarily recorded directly to each segment group based on identified customer segment.

 

   

Research and development expenses are primarily shared across the segment groups based on relative gross margin but are mapped directly in certain cases where the value of the expense only accrues to that segment group.

 

   

General and administrative expenses are primarily allocated based on relative gross margin.

Certain corporate-level activity is not allocated to our segment groups, including costs of: legal, including expenses, settlements, and fines; information technology; human resources; finance; and excise taxes.

 

26


PART I

Item 1

 

Segment revenue and gross margin were as follows during the periods presented:

 

(In millions)                  


Three Months Ended September 30,         2013     2012  
Revenue       

Devices and Consumer            

   Licensing    $ 4,343      $ 4,678   
    

Hardware

     1,485        1,084   
    

Other

     1,635        1,400   


 


    

Total Devices and Consumer

   $ 7,463      $ 7,162   

Commercial

   Licensing    $ 9,594      $ 8,945   
    

Other

     1,603        1,248   


 


    

Total Commercial

   $ 11,197      $ 10,193   

Corporate and Other

          (131     (1,347


 


Total revenue

        $   18,529      $   16,008   
         


 


 

(In millions)       


Three Months Ended September 30,         2013     2012  
Gross Margin       

Devices and Consumer            

   Licensing    $ 3,925      $ 4,103   
    

Hardware

     206        448   
    

Other

     352        362   


 


    

Total Devices and Consumer

   $ 4,483      $ 4,913   

Commercial

   Licensing    $ 8,801      $ 8,183   
    

Other

     275        105   


 


    

Total Commercial

   $ 9,076      $ 8,288   

Corporate and Other

          (144     (1,361


 


Total gross margin

        $   13,415      $   11,840   
         


 


Following is operating expenses by segment group. As discussed above, we do not allocate operating expenses below cost of revenue to our segments.

 

(In millions)  


Three Months Ended September 30,    2013     2012  

Devices and Consumer

   $ 2,288      $ 2,062   

Commercial

     4,022        3,635   

Corporate and Other

     771        835   


 


Total operating expenses

   $   7,081      $   6,532   
    


 


Following is operating income by segment group.

 

(In millions)  


Three Months Ended September 30,    2013     2012  

Devices and Consumer

   $ 2,195      $ 2,851   

Commercial

     5,054        4,653   

Corporate and Other

     (915     (2,196


 


Total operating income

   $   6,334      $   5,308   
    


 


 

27


PART I

Item 1

 

Corporate and Other operating income includes adjustments to conform our internal accounting policies to U.S. GAAP and corporate-level activity not specifically attributed to a segment. Significant internal accounting policies that differ from U.S. GAAP relate to revenue recognition, income statement classification, and depreciation.

Significant Corporate and Other activity was as follows:

 

(In millions)             


Three Months Ended September 30,    2013     2012  

Corporate (a)

   $ (775   $ (798

Other (adjustments to U.S. GAAP):

                

Revenue reconciling amounts (b)

     (131     (1,347 )

Cost of revenue reconciling amounts

     (13     (14 )

Operating expenses reconciling amounts

     4        (37


 


Total Corporate and Other

   $   (915   $   (2,196
    


 


 

(a)

Corporate is presented on the basis of our internal accounting policies and excludes the adjustments to U.S. GAAP that are presented separately in those line items.

 

(b)

Revenue reconciling amounts for the three months ended September 30, 2012 included $1.2 billion related to the deferral of revenue associated with pre-sales of Windows 8 to OEMs and retailers and sales of Windows 7 with an option to upgrade to Windows 8 and $189 million associated with revenue deferred on sales of the previous version of the Microsoft Office system with a guarantee to be upgraded to the new Office at minimal or no cost and pre-sales of the new Office to OEMs and retailers before general availability. Revenue reconciling amounts for the three months ended September 30, 2013 included $113 million of revenue deferrals, primarily related to pre-sales of Windows 8.1 to OEMs.

Assets are not allocated to segments for internal reporting presentations. A portion of amortization and depreciation is charged to the respective segment. It is impracticable for us to separately identify the amount of amortization and depreciation by segment that is included in the measure of segment profit or loss.

 

28


PART I

Item 1

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Board of Directors and Stockholders of Microsoft Corporation

Redmond, Washington

We have reviewed the accompanying consolidated balance sheet of Microsoft Corporation and subsidiaries (the “Corporation”) as of September 30, 2013, and the related consolidated statements of income, comprehensive income, cash flows, and stockholders’ equity for the three-month periods ended September 30, 2013 and 2012. These interim financial statements are the responsibility of the Corporation’s management.

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

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

We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheet of Microsoft Corporation and subsidiaries as of June 30, 2013, and the related consolidated statements of income, comprehensive income, cash flows, and stockholders’ equity for the year then ended (not presented herein); and in our report dated July 30, 2013 we expressed an unqualified opinion on those consolidated financial statements. In our opinion, the information set forth in the accompanying consolidated balance sheet as of June 30, 2013 is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

/ S / D ELOITTE  & T OUCHE LLP

Seattle, Washington

October 24, 2013

 

29


PART I

Item 2

 

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

RESULTS OF OPERATIONS

Note About Forward-Looking Statements

Certain statements in this report, other than purely historical information, including estimates, projections, statements relating to our business plans, objectives and expected operating results, and the assumptions upon which those statements are based, 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 without limitation, 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 which may cause actual results to differ materially from the forward-looking statements. A detailed discussion of risks and uncertainties that could cause actual results and events to differ materially from such forward-looking statements is included in the section titled “Risk Factors” (Part II, Item 1A 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, 2013 and our financial statements and accompanying Notes to Financial Statements in this Form 10-Q.

Microsoft is a technology leader focused on helping people and businesses throughout the world realize their full potential. 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 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, 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

Based on our assessment of key technology trends and our broad focus on long-term research and development of new products and services, we see significant opportunities to generate future growth.

We invest research and development resources in new products and services in these areas. The capabilities and accessibility of PCs, tablets, phones, televisions, and other devices powered by rich software platforms and applications continue to grow. With this trend, we believe the full potential of software will be seen and felt in how people use these devices and the associated services at work and in their personal lives.

Devices with end-user services

We work with an ecosystem of partners to deliver a broad spectrum of Windows devices. In some cases we build our own devices, as we have chosen to do with Xbox and Surface. In all of our work with partners and on our own devices, we focus on delivering seamless services and experiences across devices. As consumer services and hardware advance, we

 

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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 around the world.

Windows 8 reflects this shift. Launched in October 2012, Windows 8 was designed to unite the light, thin, and convenient aspects of a tablet with the power of a PC. The Windows 8 operating system includes the Windows Store, which offers a large and growing number of applications from Microsoft and partners for both business and consumer customers. The general availability of Windows 8.1, which will enable new hardware and further the integration with other Microsoft services, started on October 17, 2013.

Going forward, our strategy will focus on creating a family of devices and services for individuals and businesses that empower people around the globe at home, at work, and on the go, for the activities they value most. This strategy will require investment in datacenters and other infrastructure to support our services, and will bring continued competition with Apple, Google, and other well-established and emerging competitors. We believe our history of powering devices such as Windows PCs and Xbox, as well as our experience delivering high-value experiences through Office and other applications, will position us for future success.

Services for the enterprise

Today, businesses face important opportunities and challenges. Enterprises are asked to deploy technology that drives business strategy forward. 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. At the same time, they must manage and secure corporate information that employees access across a growing number of personal and corporate devices.

To address these opportunities, businesses look to our world-class business applications like Office, Exchange, SharePoint, Lync, Yammer, Microsoft Dynamics, and our business intelligence solutions. They rely on our technology to manage employee corporate identity and to protect their corporate data. And, increasingly, businesses of all sizes are looking to Microsoft to realize the benefits of the cloud.

Helping businesses move to the cloud is one of our largest opportunities. Cloud-based solutions provide customers with software, services, and content over the Internet by way of shared computing resources located in centralized data centers. The shift to the cloud is driven by three important economies of scale: larger data centers can deploy computational resources at significantly lower cost per unit than smaller ones; larger data centers 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. Because of the improved economics, the cloud offers unique levels of elasticity and agility that enable new solutions and applications. For businesses of all sizes, the cloud creates the opportunity to focus on innovation while leaving non-differentiating activities to reliable and cost-effective providers.

We continue to design and deliver cloud solutions that allow our customers to use both the cloud and their on-premise assets however best suits their own needs. For example, a company can choose to deploy Office or Microsoft Dynamics on premise, as a cloud service, or a combination of both. With Windows Server 2012, Windows Azure, and System Center infrastructure, businesses can deploy applications in their own datacenter, a partner’s datacenter, or in Microsoft’s datacenter with common security, management, and administration across all environments, with the flexibility and scale they desire. These hybrid capabilities allow customers to fully harness the power of the cloud so they can achieve greater levels of efficiency and tap new areas of growth.

Our future opportunity

There are several distinct areas of technology that we are focused on driving forward. Our goal is to lead the industry in these areas over the long-term, which we expect will translate to sustained growth well into the future. We are investing significant resources in:

 

   

Developing new form factors that have increasingly natural ways to use them, including touch, gesture, and speech.

 

   

Applying machine learning to make technology more intuitive and able to act on our behalf, instead of at our command.

 

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Building and running cloud-based services in ways that unleash new experiences and opportunities for businesses and individuals.

 

   

Establishing our Windows platform across the PC, tablet, phone, server, and cloud to drive a thriving ecosystem of developers, unify the cross-device user experience, and increase agility when bringing new advances to market.

 

   

Delivering new high-value experiences with improvements in how people learn, work, play, and interact with one another.

We believe the breadth of our devices and services portfolio, our large, global partner and customer base, and the growing Windows ecosystem 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. Some of our traditional businesses such as the Windows operating system are in a period of transition. Our competitors are developing new devices and deploy 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. The Windows ecosystem must continue to evolve and adapt, over an extended time, in pace with this changing environment. To support our strategy of offering a family of devices and services designed to empower our customers for the activities they value most, we announced a change in our organizational structure in July 2013. Through this realignment our goal is to become more nimble, collaborative, communicative, motivated, and decisive. Even if we achieve these benefits, the investments we are making in devices and infrastructure to support our cloud-based services will increase our operating costs and may decrease our operating margins.

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 worldwide by offering broad customer reach, scale in resources, and competitive compensation.

Aggregate demand for our software, services, and hardware is correlated to global macroeconomic 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).

Unearned Revenue

Quarterly and annual revenue may be impacted by the deferral of revenue. See the discussions within Corporate and Other below regarding:

 

   

revenue deferred on pre-sales of Windows 8.1 to original equipment manufacturers (“OEMs”) and retailers before general availability (“Windows 8.1 Pre-Sales”);

 

   

revenue deferred on sales of Windows 7 with an option to upgrade to Windows 8 Pro at a discounted price (the “Windows Upgrade Offer”) and pre-sales of Windows 8 to OEMs and retailers before general availability (collectively, the “Windows Deferral”); and

 

   

revenue deferred on sales of the previous version of the Microsoft Office system, with a guarantee to be upgraded to the new Office at minimal or no cost (the “Office Upgrade Offer”) and pre-sales of the new Office to OEMs and retailers before general availability (collectively, the “Office Deferral”).

If our customers elect 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 16 – Segment Information of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) is also presented on this basis. All differences between our internal management reporting basis and accounting principles generally accepted in the U.S. (“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.

 

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During the first quarter of fiscal year 2014, we changed our organizational structure as part of our transformation to a devices and services company. As a result of these changes, information that our chief operating decision maker regularly reviews for purposes of allocating resources and assessing performance changed. Therefore, we have recast certain prior period amounts to conform to the way we internally manage and monitor segment performance during the current fiscal year. Our reportable segments are described below.

Devices and Consumer (“D&C”)

Our D&C segments develop and market 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 (collectively, “Consumer Windows”); non-volume licensing of Microsoft Office, comprising the core Office product set, for consumers (“Consumer Office”); Windows Phone, including related patent licensing; and certain other patent licensing revenue;

 

   

D&C Hardware , comprising: the Xbox 360 gaming and entertainment console and accessories, second-party and third-party video games, and Xbox LIVE subscriptions (“Xbox Platform”); Surface; and Microsoft PC accessories; and

 

   

D&C Other , comprising: Resale, including Windows Store, Xbox LIVE transactions, and the Windows Phone Marketplace; search advertising; display advertising; Subscription, comprising Office 365 (“O365”) Home Premium; Studios, comprising first-party video games; our retail stores; and certain other consumer products and services not included in the categories above.

Commercial

Our Commercial segments develop and market software and services designed to increase individual, team, and organization productivity and efficiency, and to simplify 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, and System Center; Windows Embedded; volume licensing of the Windows operating system, excluding academic (“Commercial Windows”); Microsoft Office for business, including Office, Exchange, SharePoint, and Lync (“Commercial Office”); Client Access Licenses, which provide access rights to certain server products (“CAL”); Microsoft Dynamics business solutions, excluding Dynamics CRM Online; and Skype; and

 

   

Commercial Other , comprising: Enterprise Services, including Premier product support services and Microsoft Consulting Services; Cloud Services, comprising O365, excluding O365 Home Premium (“Commercial O365”), other Microsoft Office online offerings, Dynamics CRM Online, and Windows Azure; and certain other commercial products and online services not included in the categories above.

SUMMARY RESULTS OF OPERATIONS

Summary

 

(In millions, except percentages and per share amounts)   

Three Months Ended

September 30,

   

Percentage

Change

 


     2013     2012        

Revenue

   $    18,529      $    16,008        16%   

Operating income

   $ 6,334      $ 5,308        19%   

Diluted earnings per share

   $ 0.62      $ 0.53        17%   


Revenue increased, mainly due to higher Commercial Licensing, D&C Hardware, and Commercial Other revenue. Revenue was also impacted by the timing of revenue deferrals.

 

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Operating income increased, reflecting higher revenue and lower general and administrative expenses, offset in part by higher cost of revenue, sales and marketing expenses, and research and development expenses. Key changes in cost of revenue and operating expenses were:

 

   

Cost of revenue increased $946 million or 23%, primarily due to Surface product costs, as well as higher datacenter and headcount-related expenses.

 

   

Sales and marketing expenses increased $359 million or 12%, due mainly to increased advertising of Windows Phone 8 and Surface and higher headcount-related expenses, as well as due to higher fees paid to third-party enterprise software advisors.

 

   

Research and development expenses increased $307 million or 12%, due mainly to higher capitalization of certain costs in the prior year.

 

   

General and administrative expenses decreased $117 million or 10%, primarily due to lower legal charges.

SEGMENT RESULTS OF OPERATIONS

Devices and Consumer

 

(In millions, except percentages)   

Three Months Ended

September 30,

   

Percentage

Change

 


     2013     2012        
Revenue                   

Licensing

   $      4,343      $      4,678        (7)%   

Hardware

     1,485        1,084        37%   

Other

     1,635        1,400        17%   


 


       

Total revenue

   $ 7,463      $ 7,162        4%   
    


 


       
Gross Margin                   

Licensing

   $ 3,925      $ 4,103        (4)%   

Hardware

     206        448        (54)%   

Other

     352        362        (3)%   


 


       

Total gross margin

   $ 4,483      $ 4,913        (9)%   
    


 


       

Devices and Consumer revenue increased $301 million or 4%, reflecting continued adoption of the Windows platform, including customer adoption of new Windows-enabled devices. Devices and Consumer gross margin declined $430 million or 9%, due mainly to our preparation for new product launches.

D&C Licensing

D&C Licensing revenue decreased $335 million or 7%, due mainly to lower revenue from licenses of Windows OEM and Consumer Office, offset in part by increased Windows Phone revenue. Windows OEM revenue declined $237 million or 7%, reflecting a 22% decrease in OEM non-Pro revenue, offset in part by a 6% increase in OEM Pro revenue. Consumer Office revenue declined $217 million or 23%. These decreases resulted primarily from the impact on revenue of a decline in consumer demand. In the case of Consumer Office, the decline was also influenced by the transition of customers to O365 Home Premium, offset by increased levels of Office attached to devices shipped. Windows Phone revenue increased $102 million, including an increase in patent licensing revenue.

D&C Licensing gross margin decreased $178 million or 4%, due to decreased revenue, offset in part by a $157 million or 27% decrease in cost of revenue. D&C Licensing cost of revenue decreased, due mainly to lower traffic acquisition costs.

D&C Hardware

D&C Hardware revenue increased $401 million or 37%, due primarily to Surface revenue of $400 million. The general availability of Surface RT and Surface Pro started October 26, 2012 and February 9, 2013, respectively.

D&C Hardware gross margin decreased $242 million or 54%, due to a $643 million or 101% increase in cost of revenue, offset in part by higher revenue. D&C Hardware cost of revenue increased, primarily due to $645 million higher Surface cost of revenue. Surface product costs increased with higher volumes sold, while other costs grew as we ready inventory lines for the Surface 2 launch and the holiday sales cycle.

 

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D&C Other

D&C Other revenue increased $235 million or 17%, due mainly to higher advertising revenue, which increased $106 million or 13%. Search advertising revenue growth was offset in part by a decline in display advertising revenue. Search advertising revenue increased 47%, due primarily to increased revenue per search resulting from ongoing improvements in ad products and higher search volume, offset in part by lower display advertising revenue, which was down 31%, due mainly to a decline in Outlook.com advertising revenue. D&C Other revenue also increased $129 million or 21%, primarily due to higher volumes of content resold through our online platforms.

D&C Other gross margin decreased slightly, due to a $245 million or 24% increase in cost of revenue, substantially offset by higher revenue. D&C Other cost of revenue increased, due mainly to a $99 million or 20% increase in advertising cost of revenue, reflecting increased investment in online infrastructure and higher traffic acquisition costs. D&C Other cost of revenue also increased, due mainly to royalty costs on higher volumes of resale transactions.

Commercial

 

(In millions, except percentages)   

Three Months Ended

September 30,

   

Percentage

Change

 


     2013     2012        
Revenue                   

Licensing

   $ 9,594      $ 8,945        7%   

Other

     1,603        1,248        28%   


 


       

Total revenue

   $      11,197      $      10,193        10%   
    


 


       
Gross Margin                   

Licensing

   $ 8,801      $ 8,183        8%   

Other

     275        105        162%   


 


       

Total gross margin

   $ 9,076      $ 8,288        10%   
    


 


       

Commercial revenue increased $1.0 billion or 10%, reflecting growth in our traditional businesses as well as adoption by customers of our cloud services. Commercial gross margin increased $788 million or 10%, in line with revenue growth.

Commercial Licensing

Commercial Licensing revenue increased $649 million or 7%, due primarily to increased revenue from our server, CAL, and Office licenses offset in part by the transition of customers to Commercial O365. Annuity revenue grew 8% driven by growth in revenue from volume licensing with Software Assurance. Non-annuity revenue grew 4% driven by increased sales of Office and SQL Server.

Commercial Licensing gross margin increased $618 million or 8%, due to higher revenue, offset in part by a $31 million or 4% increase in cost of revenue.

Commercial Other

Commercial Other revenue increased $355 million or 28%, due to higher Cloud Services revenue and Enterprise Services revenue. Cloud Services revenue grew $261 million or 103%, due mainly to higher revenue from Commercial O365. Enterprise Services revenue grew $93 million or 9%, due to growth in both Premier product support and consulting services.

Commercial Other gross margin increased $170 million or 162%, due to higher revenue, offset in part by a $185 million or 16% increase in cost of revenue. The increase in cost of revenue was due mainly to higher datacenter expenses, reflecting investment in online operations infrastructure, and increased headcount-related expenses due to higher headcount.

 

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Corporate and Other

 

(In millions, except percentages)   

Three Months Ended

September 30,

   

Percentage

Change

 


     2013     2012        

Revenue

   $        (131   $     (1,347     90%   

Gross margin

   $ (144   $ (1,361     89%   


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 $1.2 billion or 90%, primarily due to the timing of revenue deferrals. During the first quarter of fiscal year 2014, we deferred $113 million of revenue, primarily related to Windows 8.1 Pre-Sales. During the first quarter of fiscal year 2013, we deferred $1.2 billion and $189 million of revenue related to the Windows Deferral and Office Deferral, respectively.

Corporate and Other gross margin increased $1.2 billion or 89%, due mainly to increased revenue.

COST OF REVENUE

Cost of Revenue

 

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


     2013     2012        

Cost of revenue

   $      5,114      $      4,168        23%   

As a percent of revenue

     28     26     2ppt   


Cost of revenue includes: manufacturing and distribution costs for products sold, including Xbox and Surface, and programs licensed; operating costs related to product support service centers and product distribution centers; costs incurred to include software on PCs sold by OEMs, to drive traffic to our websites, and to acquire online advertising space (“traffic acquisition costs”); costs incurred to support and maintain Internet-based products and services, including datacenter costs and royalties; warranty costs; inventory valuation adjustments; costs associated with the delivery of consulting services; and the amortization of capitalized research and development costs.

Cost of revenue increased, primarily due to a $645 million increase in Surface product costs, as well as higher datacenter and headcount-related expenses. Datacenter expenses increased $185 million or 51%, reflecting investment in online operations infrastructure. Headcount-related expenses increased $132 million or 13%, largely related to increased headcount within our Commercial Other segment.

 

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OPERATING EXPENSES

Research and Development

 

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


     2013     2012        

Research and development

   $      2,767      $      2,460        12%   

As a percent of revenue

     15     15     0ppt   


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, primarily reflecting higher capitalization of certain costs in the prior year, mainly related to Office 2013 and Windows 8.

Sales and Marketing

 

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


     2013     2012        

Sales and marketing

   $      3,304      $      2,945        12%   

As a percent of revenue

     18     18     0ppt   


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

Sales and marketing expenses increased, the largest driver of which was a $111 million or 37% increase in advertising, largely for Windows Phone 8 and Surface. Sales and marketing expenses also increased due to higher headcount-related expenses, largely related to our retail stores, and higher fees paid to third-party enterprise software advisors.

General and Administrative

 

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


     2013     2012        

General and administrative

   $      1,010      $      1,127        (10)%   

As a percent of revenue

     5     7     (2)ppt   


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

General and administrative expenses decreased, due mainly to a $73 million decrease in legal charges.

 

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OTHER INCOME (EXPENSE)

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

 

(In millions)             


Three Months Ended September 30,    2013     2012  

Dividends and interest income

   $         179      $         159   

Interest expense

     (118     (95

Net recognized losses on investments

     (7     (15

Net gains (losses) on derivatives

     (86     4   

Net gains (losses) on foreign currency remeasurements

     26        (29

Other

     80        202   


 


Total

   $ 74      $ 226   
    


 


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 (“OCI”) until the securities are sold or other-than-temporarily impaired, at which time the amounts are reclassified from accumulated other comprehensive income (“AOCI”) into other income (expense).

Net gains on derivatives decreased due to lower gains on commodity derivatives and higher losses on foreign exchange derivatives in the current period as compared to the comparable period. Other reflects recognized gains on divestitures, including the gain recognized upon the divestiture of our 50% share in the MSNBC joint venture in fiscal year 2013.

INCOME TAXES

Our effective tax rates were approximately 18% and 19% for the three months ended September 30, 2013 and 2012, respectively. Our effective tax rate was lower than the U.S. federal statutory rate primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers in Ireland, Singapore, and Puerto Rico.

This quarter’s effective tax rate was lower than the prior year’s first quarter effective tax rate, primarily due to foreign earnings taxed at lower tax rates.

Tax contingencies and other tax liabilities were $9.0 billion and $9.4 billion as of September 30, 2013 and June 30, 2013, respectively, and were included in other long-term liabilities. While we settled a portion of the I.R.S. audit for tax years 2004 to 2006 during the third quarter of fiscal year 2011, we remain under audit for these 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, 2013, the primary unresolved issue related to transfer pricing which could have a significant impact on our financial statements if not resolved favorably. We do not believe it is reasonably possible that the total amount of unrecognized tax benefits will significantly increase or decrease within the next 12 months, as we do not believe the remaining open issues will be resolved within the next 12 months. We also continue to be subject to examination by the I.R.S. for tax years 2007 to 2012.

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 2012, some of which are currently under audit by local tax authorities. The resolutions of these audits are not expected to be material to our financial statements.

FINANCIAL CONDITION

Cash, Cash Equivalents, and Investments

Cash, cash equivalents, and short-term investments totaled $80.7 billion as of September 30, 2013, compared with $77.0 billion as of June 30, 2013. Equity and other investments were $12.0 billion as of September 30, 2013 compared to $10.8

 

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billion as of June 30, 2013. 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. While we own certain mortgage-backed and asset-backed fixed-income securities, our portfolio as of September 30, 2013 does not contain direct exposure to subprime mortgages or structured vehicles that derive their value from subprime collateral. The majority of our mortgage-backed securities are collateralized by prime residential mortgages and carry a 100% principal and interest guarantee, primarily from Federal National Mortgage Association, Federal Home Loan Mortgage Corporation, and Government National Mortgage Association.

We routinely monitor our financial exposure to both sovereign and non-sovereign borrowers and counterparties. Our gross exposures to our customers and investments in Portugal, Italy, Ireland, Greece, and Spain are individually and collectively not material.

Of the cash, cash equivalents, and short-term investments at September 30, 2013, approximately $76.0 billion was held by our foreign subsidiaries and would be subject to material repatriation tax effects. The amount of cash, cash equivalents, and short-term investments held by foreign subsidiaries subject to other restrictions on the free flow of funds (primarily currency and other local regulatory) was approximately $1.0 billion. As of September 30, 2013, approximately 88% of the cash equivalents and short-term investments held by our foreign subsidiaries were invested in U.S. government and agency securities, approximately 4% were invested in corporate notes and bonds of U.S. companies, and approximately 2% 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 $582 million as of September 30, 2013. Our average and maximum securities lending payable balances for the three months ended September 30, 2013 were $595 million and $765 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, foreign government bonds, mortgage-backed securities, and U.S. agency securities. Level 3 investments are valued using internally developed models with unobservable inputs. Assets and liabilities measured 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.

 

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PART I

Item 2

 

Cash Flows

Cash flows from operations decreased slightly by $279 million or 3%, to $8.2 billion, primarily due to changes in working capital. Cash used in financing increased $682 million or 25%, to $3.4 billion, due mainly to $1.0 billion in debt repayments, a $556 million increase in cash used for common stock repurchases, and a $240 million increase in dividends paid, partially offset by $1.3 billion in issuances of commercial paper. Cash used in investing decreased $3.1 billion or 40%, to $4.6 billion, due mainly to a $2.3 billion decrease in cash used for net investment purchases, sales, and maturities, and a $1.1 billion decrease in cash used for acquisition of companies and purchases of intangible and other assets, partially offset by a $628 million increase in capital expenditures for property and equipment.

Debt

As of September 30, 2013, we had $15.9 billion of issued and outstanding debt, comprising $1.3 billion of commercial paper and $14.6 billion of long-term debt, including the current portion.

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.

Short-term debt

As of September 30, 2013, we had $1.3 billion of commercial paper issued and outstanding, with a weighted-average interest rate of 0.10% and maturities of 70 to 98 days. The estimated fair value of this commercial paper approximates its carrying value.

In June 2013, we entered into a $1.3 billion credit facility, which serves as a back-up for our commercial paper. As of September 30, 2013, 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. The credit facility expires on June 24, 2018. No amounts were drawn against the credit facility since its inception.

Long-term debt

As of September 30, 2013, the total carrying value and estimated fair value of our long-term debt, including the current portion, were $14.6 billion and $14.5 billion, respectively. This is compared to a carrying value and estimated fair value of $15.6 billion and $15.8 billion, respectively, as of June 30, 2013. These estimated fair values are based on Level 2 inputs.

 

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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, 2013:

 

Due Date    Face Value    

Stated
Interest

Rate

    

Effective
Interest

Rate

 


     (In millions)               
Notes                    

June 1, 2014

   $ 2,000        2.950%         3.049%   

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%   

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%   

November 15, 2022

     750        2.125%         2.239%   

May 1, 2023

     1,000        2.375%         2.465%   

May 2, 2033  (a)

     745        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%   


                

Total

   $ 14,695                    
    


                

 

(a)

In April 2013, we issued €550 million of debt securities.

The notes are senior unsecured obligations and rank equally with our other unsecured and unsubordinated debt outstanding. Interest on the notes is paid semi-annually, except for the euro-denominated debt securities on which interest is paid annually. As of September 30, 2013, the aggregate unamortized discount for our long-term debt, including the current portion, was $63 million.

Unearned Revenue

Unearned revenue at September 30, 2013 comprised mainly 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, 2013 also included payments for: post-delivery support and consulting services to be performed in the future; Xbox LIVE subscriptions and prepaid points; OEM minimum commitments; Microsoft Dynamics business solutions products; Skype prepaid credits and subscriptions; Office 365 Home Premium 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.

The following table outlines the expected future recognition of unearned revenue as of September 30, 2013:

 

(In millions)       


Three Months Ending,       

December 31, 2013

   $ 8,039   

March 31, 2014

     6,148   

June 30, 2014

     3,417   

September 30, 2014

     981   

Thereafter

     1,629   


Total

   $   20,214   
    


 

41


PART I

Item 2

 

Share Repurchases

During the three months ended September 30, 2013, we repurchased 46.8 million shares of Microsoft common stock for $1.5 billion under the share repurchase plan we announced on September 22, 2008. All repurchases were made using cash resources. On September 16, 2013, our Board of Directors approved a new $40.0 billion share repurchase program, which replaced the share repurchase program that expired September 30, 2013. The new share repurchase program became effective on October 1, 2013, has no expiration date, and may be suspended or discontinued at any time without notice.

Dividends

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

 

Declaration Date    Dividend
Per Share
    Record Date      Total Amount     Payment Date  


                  (in millions)        

September 16, 2013

     $  0.28