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  • 1. Microsoft Strategic Update Steve Ballmer, Chris Liddell February 24, 2009 CHRIS LIDDELL: Okay. Sorry about that. Thank you again. So let me make a few introductory comments. I'm going to hand it over to Steve for the bulk of the presentation, and then both of us will take questions and answers at the end. So let me just start with the normal health warning. I'm sure you're all familiar with this, but just to go over it again, statements in the presentation that are forward-looking statements about Microsoft are based on current expectations and assumptions that are subject to risks and uncertainties. Additional information concerning factors that could cause results to differ materially from those discussed in any forward-looking statement are contained in the management discussion and analysis of financial conditions and results of operations. Also, you can obviously go to our Web site for additional information, that's www.microsoft.com/msft. So I would like to just set the context of the presentation. As you recall, the purpose of the meeting this morning that we've held now for a few years is to give you a midyear summary of our strategic thinking, in particular to bridge the Financial Analyst Meeting that we do in July that I know a number of you come to, and update our thinking for anything that's changed since that time. And clearly the most significant thing that's changed since last July really is the state of the economy. When you look at that in the context of our H1 results, our results actually weren't bad. But the shape of the results I think is probably the most significant. If you look at the absolute numbers from our first half, we had $31.7 billion of revenue, up 5 percent year on year, so an improving revenue. We made $11.9 billion of operating income. So even though the revenue was less than what we were expecting going into the year, we were able to make up for most of the shortfalls through operating expense savings, and still grow positively on the revenue base. We made earnings per share of close to a dollar. We continued the policy that we've had of increasing dividends year on year broadly in line with earnings growth. And we did $8.2 billion dollars worth of share buyback. So we used more than our free cash flow for the half of the share buyback. If you look at the numbers, just the raw numbers, it was actually a very good first half. Clearly the most significant thing was the shape of the results through the year. The first quarter was generally in line with expectations. The second quarter lower than expectations and in particular the second half of the second quarter. So we saw operating conditions being generally still reasonably sanguine through September-October, continued to deteriorate through November and December. So that really set us up for the second half, which I know a number of you listened to and subsequently talked to me about in terms of the context for H2.
  • 2. As we look forward to H2, clearly we expect, and I think all of the news that you see at the moment since we did our earnings call, since the end of the last calendar year, we expect conditions to remain difficult through at least the second half of this year, the second half of our fiscal year, the first half of the calendar year. When you look at the individual businesses, the trends that I've talked about in the earnings call really are still how we see things going forward. So in the Client business in particular likely to be impacted by a lot of the same trends that we saw in the later half of the second quarter of last year. So deteriorating PC sales from our traditional consumer and business markets, both in developed and emerging markets, offset to some extent through our netbook sales, and increasing netbooks as a percentage of overall PC sales. In our Microsoft Business Division just under half of that is affected what we describe as transactional sales, or non-annuity sales. They are also likely to be influenced by the overall PC market, in particular the trends I describe as the traditional PC sales. So there's deteriorating environments there. Just over half is more annuity business, so more proportional to the overall IT cycle, which admittedly is slowing, but will offset some of the negatives obviously on the non-annuity side. Server and Tools, similar situation to MBD, in their case about a third of the business is non-annuity, likely to be impacted in this case by server sales. When you look at the third party estimates, clearly a deteriorating situation for server as well. Not so much as the PC environment, but still a negative environment for the second half of this year. Two-thirds of their business is annuity, so the Server and Tools Business, as we saw in the second quarter, was the one that held up the best. It's likely to continue to do that in the second half of this year as well. On our Online Business, OSB, again, similar trends. We expect continuing through the second quarter through to the second half. So advertising sales under pressure, likely to continue that way in particular until the economy turns, which we're saying is unlikely to be certainly in this six month period, in particular on the display side. So, again, a continuation of the trends we saw in the second quarter. And Entertainment and Devices, we're obviously very happy with the position we've done there, in particular Xbox, but again it will also be to some extent impacted by consumer sales and consumer spending overall. So all of the businesses to a greater or lesser extent will be impacted by the economy. Steve will talk a bit more about that, how much we see is economy driven versus Microsoft specific factors. But overall picture, a difficult economy for the second half of this year. Against that background, as you know, we took some initiatives starting in the first quarter, ramping up in the second quarter, and going through the second half on the expense side. That means that we've been able to reduce our expense expectations
  • 3. relative to the start of the year by $1-1/2 billion, and CAPEX by about $700 million. So we've taken down the expense base relatively significantly for this year. In terms of FY '10, we also talked on the call about our expectations of how we're going to manage expenses in this environment going forward to next year, and we see expenses being broadly flat in Fiscal Year '10, relative to Fiscal '09, and CAPEX actually going down. So revenue side overall difficult, expense side clearly we're looking to manage that more intensively, and so the big themes from my point of view in the second half, which will also reflect what Steve will be talking about, on the revenue side, given the environment that we're delivered, how do we compete for share, and with the share that we have how do we maximize the revenue per unit of share that we're able to do. That's our real focus on the revenue side. On the cost side, how do we reduce costs in the most prudent fashion, and where to invest that money. To the extent that we make investments and spend money, how do we prioritize it, and how do we most effectively spend it. And last, but not least, in particular from my perspective, how do we manage our balance sheet, and how do we manage our cash flow. We're in the fortunate position in this environment of having a triple A balance sheet, and effectively, or virtually no debt, an still strong cash inflows. So how we manage our cash flow, and how we manage the balance sheet in this environment is clearly one of the strengths that we have in terms of the opportunities that are most likely to grow up. So those are the big themes for the second half, that sort of context. It's a very similar message to what I gave a month or so ago on our earnings call. So no significant change, a continuation of the themes that we've seen. With those context, I would like to hand it over to Steve who is going to give you an update on the strategic thinking, and how that's developing. STEVE BALLMER: Okay. Thanks. As we were collecting at 8:00 a.m., I wasn't sure whether we had hit New York protocol, or whether 9:00 a.m. would have been better, but I will say 8:00 a.m. is 5:00 a.m. in Seattle, so we'll try to bring a little energy to the presentation nonetheless. I'm going to start with just a brief word on the economy, and then I really do want to talk about the strategy of the business, because nobody really knows kind of what we have. I think, in fact, that's probably fair to say. We've had our guys go back and kind of do a little reading, our small little corporate strategy group, on all of the economic downturns in the U.S. that were driven by deleveraging of the economy, how long did they last, what did they look like. We even had some guys go through and read the annual reports of a bunch of companies from 1927 through about 1938 to try to get, well, what were those guys saying, what was going on, who did a good job? RCA, god rest them in peace, RCA become our role model. They actually kept investing in R&D through the Depression period, and the post-Depression they dominated TV
  • 4. technology because they were really the only guys who had invested. And there's a lot of good learning if you go back and take a look, there were four in U.S. history massive deleveragings that led to economic downturns, 1820s, 1873, 1929, and the present, and they all have a story associated with them, and none of them is a quick recovery. Let's just say it that way. I know economic science has progressed, but that's why I also think of this as an economic reset. It's not a recession in which you recover, but rather a bunch of money comes out of the economy, it resets over a period of time to a new level, and then productivity and sort of innovation can then again drive economic growth. And that's kid of the mindset that we have relative to the economic situation. You don't beat it. You manage in this environment. You don't think about it as shorter term, you think about it as a rest that may take several years to fully reset, but we need to then really ask the question, what do we invest in, what's important, what's going to happen. I don't think, and certainly the earnings reports we see from everybody, I don't think anybody is able to cut costs fast enough in any industry to maintain the profits of yesteryear. So you've got to ask, what does the business reset look like that goes along with the economic reset. And I'm going to talk to you about kind of where we are strategically in that process. There's a picture I sometimes feel like I try something new every year, either at FAM or at this meeting, trying to connect, trying to really explain how we think about our business, and I'm trying another vehicle today. They're all right, but sometimes if you see things through a couple of different perspectives it's helpful. If you take a look at Microsoft and what we invest in, in a sense you could say there's seven big businesses, there's a bucket that I call other businesses in the kind of middle right. We certainly invest in research and the incubation of new technologies, and new ideas, and then unfortunately every company has got a corporate overhead and G&A associated with it that we invest in. Windows, Windows Mobile, and those two will become I'd say closer in many ways. There's still a real distinction between what's a phone and what's a PC. And yet the amount of technology that can be shared across that border continues to go up. So PCs, phones, desktops, productivity, which has been in a sense our biggest business, if you will, servers, enterprise software, in our case enterprise software doesn't really include ERP and the like, but it includes the equivalent of, say, Oracle's database, and middleware business, the software that forms the backbone for enterprise applications, platform, if you will, search and advertising, and I broke the portal MSN out, because at the end of the day the cleanest, best business, advertising-based business on the web is not the portal, it's actually the search business, and the portal supports it, but search is a better business than Yahoo's portal, our portal, Facebook's portal, anybody else's. The one that is the machine is search, so that's search and advertising, and then I put entertainment and TV together, and that to me refers in our case to a number of initiatives. The Zune software, I took out the Zune hardware, because it's a kind of
  • 5. special purpose device for us that reinforces our strategy, our Media Room software, what we're trying to do with Xbox. Then you get a set of other businesses, Dynamics, MSN, hardware, enterprise services, Zune hardware, and those things all reinforce in some senses what we're trying to do in the big seven, but it's the big seven in which we invest serious money. It's the big seven in which we expect serious economic return. It's the big seven that I'm going to talk to you abut today, and it helps frame. We told you that OPEX would be about $27-1/2 billion. R&D will be about $9-1/2 billion of that. Sales and marketing is close to $14 billion. And the overall G&A is about $4 billion. I'll describe that a little bit more on the next slide. So that's kind of a picture of how you can think about what we choose to invest in as a company. If you take a look at it in a different lens today, and you ask which of these businesses are profitable, let me actually say very profitable, profitable, somewhat unprofitable, and very unprofitable. Windows is very profitable. That's a green. Windows Mobile, Windows Mobile is somewhat unprofitable. That's a yellow. Desktop productivity very profitable, server very profitable, enterprise software very profitable, search and ads very unprofitable, entertainment and TV profitable. And these other businesses that support what we're doing in aggregate are just about profitable. They are profitable, but not a lot of money. The percentages here actually indicate the percentage roughly, this is not GAAP accounting, it does not reflect our segments. I took another cut on it, because what you're going to see is I'm also going to try to compare to our main competitor. But, in a sense we do go to market this way. We organize ourselves. We create our segments around technology and market. This is really more a pure market-driven, customer-driven, competitive driven view. We spend about 16 percent of our OPEX on Windows, 4 percent on Windows Mobile, 28 percent on this thing I call desktop productivity, 8 percent on the server, 10 percent on enterprise software, 7 on search, 6 on entertainment and TV, 10 on all these other businesses, 1 in research, and 2 in incubation of new businesses, and then now I've sort of really made this the pure enterprise. What does it cost us to open the door, run the legal department, the HR department, IT, accounting, that costs us about 8 percent. That's a bigger number than I'd like it to be, but I think it's probably fair to say that because we're an IP-based business, and because our history, particularly our legal budget is likely to be bigger than the legal budget of the average company of our size, unavoidably at this stage I would say. So it gives you a rough roadmap of where we're making money, and about how much, and about how we are allocating the $27-1/2 billion of OPEX. I talk a lot about OPEX, because my basic theory on COGS is in general we're trying to minimize the amount of COGS it takes to deliver on the business and revenue model that we're working on. So despite the fact that we've told you what the cost base will look like for next year, there are people who are coming to work every day asking how do we
  • 6. continue to reduce COGS. But unlike many companies, or at least in our industry we're similar, in most industries people do most of their best cost work actually on the COGS structure. And OPEX is harder to work. On our side we're working on OPEX, and actually we have pretty good tools for working on the manufacturing, the service delivery cost, et cetera. So this is kind of the rough blueprint, and I think it tells you -- gives you a sense of the importance of the things that we are doing. Sometimes I get asked questions like why do you stay in business foo, or business bar. Mostly I get asked about things that are in other businesses. They're either break even or slightly profitable, and they reinforce other things we're doing. Some of you will ask, why do you stay in search and advertising. We will stay in search and advertising. We think it's an extremely good opportunity, and it's extremely important competitively, but more on that in a minute. We'll be talking about each of the big seven businesses. Over the last few years some of these we've actually ramped the expenses in ways that I think surprise some of you. We ramped up the OPEX spending, for example, in the Windows business. It's ironic. People can say, hey, can't you improve your margin structure, sort of a question we get in aggregate. Our margin structure actually reflects the mix of the seven businesses, and are we actually needing to continue to ramp investment in some of the businesses that are very good. Take the Windows business, I think it was this meeting two years ago, maybe three years ago, I got a big push from investors, you've got to go spend more money, spend more money, buy a lot of ads. And at the time I said, no, no, no, no, we don't want to do that, that wouldn't make sense. Well, in the last year or so we've started running much more significant advertising campaigns around Windows, which I did wind up agreeing was necessary, but it's not something that is helpful, that is it's an investment area. In mobile, over the last several years we have ramped investment. In desktop productivity we've actually increased investment, primarily because we see the opportunity to increase revenue by attaching more value in the enterprise market. So we've ramped somewhat on the OPEX, and also on the revenue. Server has been relatively flat. Enterprise software has been relatively flat. Search and advertising, we've ramped our investment. Entertainment and TV, we've actually kept our investment relatively flat. And we've ramped a little bit in the incubation area, the 2 percent, in the lower right. That's kind of been the history, if you will, over the last several years. We've told you that OPEX would be roughly flat in Fiscal Year '10, and so we're kind of managing in that kind of a world, and as we need to dial things up, or dial things down, we're kind of moving things, if you will, to some degree. It's not easy, not like you can take somebody who thinks they're a videogame designer and put them to work on SQL Server, but we're doing some work to reshape our cost base. And if you really study, for example, the rifts that we've done they're primarily focused in on giving us the flexibility to eliminate positions in one part of the business, and actually open positions in another part of the business.
  • 7. So in a sense this is where we're better, this is what we're investing on, and the question is, how will we do as a company, will we be successful, how successful can we be in the context of the economy, et cetera. I'm going to take each of the seven now and just comment on it. I'm going to comment a little bit on how I think the economy affects the business. I want to talk about our share position, because you can always take share. I tell our people, I don't know why you get grim, even in a down economy we could take share, maybe especially in a down economy it's time to take share. So I'll talk about our share position. I'll also give you our own internal estimate, and that's all they are, they're our own internal estimates, of what our investment, and what competitive investment looks like in R&D, headcount, and in OPEX dollars. I'll talk about some strategies to build share, and gain position, and then a little bit I called it revenue realization, because it's not really pricing. A lot of what we do to build revenue is actually to sell more things to the same customer. Oh, Mr. Customer, you've bought the core CAL, we'd like to up-sell you to the enterprise CAL. So a lot of what we do is to try to up-sell people as opposed to just increase the price of the same thing from foo to foo-plus. On the Windows side, there's certainly going to be economic effects on PC sales. We've already seen them. They will continue. I have a basic theory that says, in the consumer market the things that get hit most in this economy are going to be big ticket items that are viewed as discretionary. The car replacement, the extra PC and the PC replacement, the flat panel TV, all of that will be affected. We cannot control it, and it will impact our revenue. On the business side, we'll see the equivalent. We'll see a slow in capital spending. IT is about 50 percent of capital spend in developed markets. So we'll see a slowdown in IT spending. And that will affect PC and PC hardware and server sales rates. So this is definitely a business that sees the effect of the economy. From a marketing share perspective, we show you on the left here you can see operating systems, and on the right you can see the browser. Windows license, number one market share, number two market share goes to Windows pirated, or unlicensed. That's a competitor that's tough to beat, they've got a good price and a heck of a product, but we're working on it. Linux, you could see on the slide, and Apple has certainly increased its share somewhat. I think depending on how you look at it, Apple has probably increased its market share over the last year or so by a point or more. And a point of market share on a number that's about 300 million is interesting. It's an interesting amount of market share, while not necessarily being as dramatic as people would think, but we're very focused in on both Apple as a competitor, and Linux as a competitor. I think the dynamic with Linux is changing somewhat. I assume we're going to see Android-based, Linux-based laptops, in addition to phones. We'll see Google more as a competitor in the desktop operating system business than we ever have before. The seams between what's a phone operating
  • 8. system and a PC operating system will change, and so we have ramped the investment in the client operating system. In the browser, IE is in red, the number two guy is Firefox in white, Safari, Chrome are still relatively small. The red connotes that we are losing share. The red does connote in this case that we have lost browser share with IE8 we are very focused in on a set of technology marketing programs, et cetera, to regain browser share. We think that browser share is important. Browsers are not commodity. Browsers are key features of operating systems, and we have a lot of work that we need to do in that dimension. On the investment side, we just chose to take Windows and mobility, client operating systems all up, so that we could get a real comparison with Apple. We think we're the big R&D spender in this area, but you should remember or R&D group is also doing shared technology for the server. I didn't try to tear that apart, so some of those 8.2 thousand people in our case are actually working on server operating system technologies. Apple, rough estimate, 5.3 thousand people, RIM already 3,000 people we think in R&D. And you can see the rough OPEX dollars. When I say OPEX dollars here I'm talking bout R&D, sales and marketing, and I took out the cost -- we took out the cost of enterprise G&A. So that's kind of renormalized, to try to say, what are we fighting against. And it is important, because as I evaluate, and as you ask questions, are you spending too much, cut, cut, cut, cut, cut, cut. We've got to take a look at this competitive environment and there's no magic number. It's not, let's go look just like Apple, let's go look like RIM, let's go look like somebody else. But we do have to have a real perspective on what the other guys are investing in R&D, and what the other guys are investing in sales and marketing. In Apple's case they essentially invest a lot more in sales and marketing as a percentage and a lot less in R&D, and that's their strategy. From our perspective we've got some big things coming from an innovation perspective. Windows 7, which has gotten some early good looks, I would say. IE8, we just shipped a new version of Windows Live. I think of Windows Live as the essential service-based component that completes the Windows experience. They are, of course, not included with Windows, that is -- I think if we were not in a consent decree type world you would think of those as one integrated offer, but that's not consistent with the current provisions of the consent degree. Netbooks and consumer PCs, I get a lot of questions about netbooks. We made a strategy a year ago that said, we will have high market share on netbooks. We priced to have high market share on netbooks. We did the marketing work to have a high market share on netbooks. Retailers were looking at the very high return rate they were getting on Linux netbooks and they said, this is the way to go, we're now I think over 90 percent attach rate against netbooks, which I'm very excited about. Netbooks have been growing nicely, while consumer PCs have been flat, non-netbook consumer PCs have been flat to slightly down.
  • 9. People say are netbooks all downside? I don't think so. I don't think the total market would be the size that it is without the netbook. And yet on the other hand we need to carefully think through what kind of pricing and value we put in netbook-specific SKUs versus full PC consumer SKUs, versus the business SKU. That's important to us. The other thing that I think is important for us to have in our heads is what the netbook may open up in terms of new possibilities for us. You now get a very lot cost, very small, essentially hardware stack that can run our software anywhere. And you can start literally thinking about embedding it in a lot of different devices. And I think we'll see an opening up of some new opportunities for us. Certainly when you talk to people like ASUS in Taiwan, you see a lot of opportunities for market unit growth, based upon that technology. Business PCs I'll just comment on, because I think they have been the most impacted so far by the economy. And at the end of the day we have a good strategy, a lot of attach, but it's really hard to make up for the fact that businesses have slowed PC purchases, and that is the highest priced SKU that we have in our lineup. From a revenue perspective, unfortunately the healthiest part of the market is the netbook, where we get the lowest revenue. The second healthiest part of the market is emerging markets, whoops that's got revenue realization challenges, primarily from piracy in addition to price. And so on. Windows 7, Windows 7 will be available on the netbook. Today the netbook is all Windows XP-based SKU, and I think as we move, and as you see us announce our strategy for Windows 7 on the netbook we're going to have a lot more opportunities in order to think through how we get the customer to want to trade up from a lower-priced offering to a higher-priced offering, and we're certainly experimenting with that. Windows Mobile, here I gave a breakout of our mobile investment versus RIM. We're below where they are, certainly, on headcount. I was surprised with all the advertising they're doing that we're not further behind on OPEX dollars, but it doesn't appear that way. From a share perspective, we live in the U.S. and we lose sight of what's really going on. The number one market share player in smart phones is actually Symbian; number two, RIM, you can see them there; number three, Microsoft; number four, Apple; Google barely registers so far, but we have to take it very seriously. The truth of the matter is, I would say all of the consumer market mojo is with Apple, to a lesser extent Blackberry, and yet the real market momentum with operators and the real market momentum with device manufacturers seems to primarily be with Windows Mobile, and with Android. And so we're sort of competing on two different fronts. We're competing in one sense, at one time, with what I consider the future, which is software that is sold independently of hardware and can have very high reach into the smart phone base, and we're competing with end-to-end solutions, hardware, software, services from the likes of -- well, not the likes of -- from Apple and from RIM.
  • 10. People ask me, will you build your own phone? Not our strategy to build our own phone. It's our strategy to sell software that we can use and support across a wide range of device manufacturers to encourage choice, choice in devices, choice in the operators. We have a positive price on our software. Google does not. I don't know how it is a sustainable thing to not have a positive price. And don't tell me you think it's search, because even when they win the Android business, they have to pay to have their search installed on that phone, just as we do, that's a competitive bid that the operators mandate. So we're going with a real price, with real investment, with a professional approach, and a positive price on software-based model. We're extending, though, we're extending our offer to include not only the core platform, but applications and services. We've made a nice release announcement last week of Windows Mobile 6.5. We've got Windows Mobile 7 coming next year. We're getting more and more synergy with Windows, so the browser improvements, et cetera, should be quite rapid. The one thing I'd say about this business in the context of the economy is, the move in the phone market from feature phones to smart phones should be more important to us economically than the contraction in the phone market. The phone market has been, whatever, 1.2 billion units, something like that, some people say it might contract, but smart phones have been just 100 to 200 million units a year. So smart phones will grow, in my opinion, even as the phone market as a whole decreases. I do think the guys who are in the best position to benefit are the guys who actually have phones at low price points. I think that's a distinct advantage that we have. We have manufacturers who have low price point phones compared to the iPhone, particularly, which is a very high priced phone. You may get subsidized down to lower prices, but the operators care a lot about what they get charged for the phone, and I think you'll see very low cost, low price form factors with Windows Mobile, possibly also with Android as well. Desktop productivity, very affected by PC sales, and on the corporate side also affected by enterprise IT spend. As Chris pointed out, we have long-term agreements that in our financials will damp the impact, particularly in the enterprise market, but this is our biggest business, it's our most profitable business, and it's a business that is not immune. From a share perspective, Office license is the biggest chunk, but you may notice that Office unlicensed is a higher percentage of this market than Windows unlicensed was of the Windows market. That, again, is both an opportunity and a challenge. Open Office we've been competing with for a number of years, but we keep competing with it. It doesn't go away. We get challenges particularly in education accounts from Open Office. We continue to have, I think, the superior offer. We have more capability, we are priced well. Some of you may have noticed we've, in fact, decreased the price of the consumer version of Office over the last year and a half around the world, and what we've found is that there's enough price elasticity that we have more than made up in unit volume for what we gave up in price per unit. So price elasticity has been positive as far
  • 11. as we have pushed it. There's not very good data here about the competitors' investments, I'm afraid. From a strategy perspective, the next big innovation milestone is Office 14, our next Office release, which will not be this year. There's a version of SharePoint. There's a version of Exchange. There's a new version of Office Live, which is the service, non- enterprise service for Office customers. I talked about some of the issues in education. This is actually a market where we make a lot more money. We get a lot more revenue realization on the enterprise Office buyer than we do the consumer Office buyer. About a third of our Office units get bought by education, very small price realization. About a third of our Office units get bought by consumers in small business, pretty small revenue realization. And about a third of our office units get bought by larger businesses, very nice revenue realization, because we're attaching so much more value. We help the user login, we help the IT department manage their desktops, we help with collaboration, we run the e-mail. So in a sense, we're far more sensitive to changes in enterprise IT spend than anything else. We have a lot of new technologies that have yet to have been sold to our enterprise customers, security management, identity management, authentication, next generation portal, collaboration, conferencing technologies, so a lot of opportunities to improve revenue realization. We've now launched fully our Exchange and SharePoint Online Services, and we're seeing very rapid uptake from our enterprise customers on that concept. Now it takes a while to get people deployed, but people like Nokia, and Coca- Cola, and many others are already moving with us to move their desktop users of e-mail, of collaboration to our cloud data centers. And then Office Live, I'd say we're still pretty early days in figuring out how to make it a better source for revenue realization for the productivity user. I'm going to just quickly run through some of these others. Server, server we are the biggest share of the market. We do have a problem with licensing here, too. We're yellow, which means our share is about stable. Linux and we have not shifted share positions, but Linux is the big competitor. Linux still dominates Web and scientific computing workloads. We about split line of business application workloads. And we generally have the lion's share of the market in what I would call desktop infrastructure, and IT infrastructure workloads. And so for us really investing to get after, in a technology sense and in a business sense, Web, Web hosting, Web applications, and scientific applications has been a major point of investment. We had when Windows 7 shipped a new release of the server. We have a new release of System Center. And we'll bring our Windows Azure, which is essentially our server platform brought to the cloud, we showed that at our PDC last year, and we ought to have significant progress, and kid of ability to go to market by the end of this year at our next Professional Developers Conference. From a revenue perspective, we are introducing a new low cost, low price, low functionality Windows server SKU. If you take a look at it, as server prices, hardware prices have come down, we don't exactly have a netbook phenomenon, but if somebody
  • 12. can buy a $500 server, they're a little loathe to spend $500 for the server operating system that goes with it. So we have something that's akin to netbook at the server level, and we'll be introducing our Foundation Edition over the next month or two. The hosting space, we have low share. We have some things we think we need to adjust in our pricing that will be important, but it probably is to the revenue or the share upside, but it's not -- it's a price decrease if you will. In the enterprise, most of what we sell is still Windows Servers, it is not Enterprise Edition. We have a chance to trade people up for scale, and most servers sold today are still not sold with management attached to them. And the opportunity for us to get every server that we sell to have a management pack associated with it is a good opportunity for us. Enterprise software, and here I'm talking about kind of database, middleware. I talked about IT budgets, but IT budgets in this business really represents more of an opportunity than a challenge. You say why is that? Well, we're only about 16 percent of the revenue in this market. Oracle is lower unit share, as you can see on the chart, but hey are a higher revenue share. We have the biggest unit share. We certainly do not have the biggest revenue share. And so in an era of tight IT budgets, I actually think the opportunity for us to take share from Oracle, who recently raised prices, has never been better. So this is kind of a double-edged sword, I would say, for us. You get a little bit of a sense that we're outmanned. These are our estimates, but I think Oracle dramatically out spends us both on the R&D side, and on the investment in sales and marketing. That means our product, and sort of price, and value proposition has to be even stronger. We've got great technology coming here. The next version of SQL Server will do some phenomenal things in business intelligence, and data warehousing. We'll have a new high end version that we call Data Center some time over the next year or so. We have an Azure version for the cloud announced that will reach fruition with the PDC this year. We've got new App Server technology to go win online transaction processing applications. New offers for the hoster. And I think if you look at our product line, we have something for everybody. We've got a free version on the low end for simple apps. We've got a low priced version for the Web for hosted applications. And then our standard Enterprise and Data Center editions give us a chance to move, move our revenue share up. The other thing which we're taking a look at is Oracle's enterprise licensing model. Oracle does do these big time site licenses which makes it hard for us to get in. I think we have some pretty clever ideas from both a sales model and a price model on how to increase our revenue and still look like a very attractive value compared to competition. Search and advertising, we are a small share. I told the guys, let's actually use global share this time, because this is a global market. We like to look at U.S. share, because U.S. is actually one of Google's weakest markets. They're actually much stronger in Europe than they are in the U.S. We and Yahoo may have almost 30 percent, but there's nobody who has almost 30 percent in France. It's all about Google. Some people say to me, why don't you just give up? This is a huge opportunity. You give up, you can't get
  • 13. back in the game. There's a certain -- and I described this at our Financial Analyst Meeting -- there's a certain Jacks or better to open in terms of technology, relevance, in terms of CAPEX, in terms of indexing the Web, and we have good ideas. This is not going to change quickly. This is a market that deserves to have a few creative teams innovating. Since I saw you last, we brought onboard to run this division Qi Lu, who was really the key technologist in the search and advertising business at Yahoo. We've brought probably independent of Qi, we've probably brought 10 other of the key technologist from Yahoo to Microsoft. We've got great talent in this area. And I think a great opportunity to really differentiate. But we are up against incredible odds. They have share, we don't have share. They have a huge team; we've got a much smaller team. You all know that I would like to figure out how to pool somehow Microsoft and Yahoo. I'm not talking about doing an acquisition, blah, blah, blah, back to search deals, blah, blah, blah, I don't know if anything is going to happen. I'll short-circuit the whole conversation, but the fact of the matter is, these two guys should somehow figure out how to get together and create more competition for this guy. And I'm hoping perhaps that that's a reasonable conversation to have with new management at Yahoo as Carol comes onboard. What's our strategy? We've got to make fast releases quickly. This is a product where we're turning new releases every six to nine months. We have another significant release that will come out this spring. We're really pushing on getting relevance in our algorithmic results, and in our advertising. Some of that is a technology problem, some of it is actually a business problem. Google has roughly three times as many advertisers in their system, and the advertisers are bidding on a far broader set of keywords in the Google system than our system. And so Google has a better database of ad listings because they have more bidders to use to pick the right ad to display. And if you show a user a page, they do view the relevance of the ad as part of the relevance of the page. So if all they get when they do a search on something are ads that look meaningless, it does impact the way the user sees the page. We're working on distributing value to buyers and sellers in new ways. You could say, hey, look, search isn't about buying and selling, and yet all of the money that is made in search is about commercial actions, it's on clicking on ads. So part of what we have got to do is give the user better tools to make decisions about things they want to buy. We've got to change the value curve so that value gets shared differently between us, the buyers and the sellers than perhaps happens on the Google system. We have to invest in marketing and distribution. At CES we announced distribution deals with Dell. We announced a distribution deal with Verizon Wireless. These are not inexpensive. They're not inexpensive because we don't have the scale that lets us monetize those deals in quite the same way that Google does. We have invest in the U.S. first, but we can't ignore particularly other developed markets where there is a very large search advertising market. We've got to drive our revenue per search by improving ad relevance. We're going to hurt our P&L, though, to some degree by investing money back in new business models in which distributors and the merchants themselves through our Live Cash Back program benefit from our economics.
  • 14. This is a tough one. We lose money. We've got, I think, some big innovations coming. But this is not a market that's going to swing from whatever that says, 3 percent, 4 percent global share, it's not going to go from 4 percent to 25 percent in a year, that's not realistic. We know we have to be responsible and reasonable about the total amount of money that we invest. I don't want to wind up being known as the Jerry Yang of this market in a different way, the guy who invested forever and got no -- and I'm not trying to be rude to Jerry, but that whole episode left me understanding how shareholders can get frustrated with managements who aren't serious about performance. I'm serious about investment, but I'm also serious about performance in this business. I think we've got the leadership. I think we've got the team. I think we've got the innovation to go there. I think we will make improvements. But I don't think the improvements are going to happen over night. But market share has got to be the first leading edge indicator, and we're going to share it with you, and have a chance to talk about it with you. Last, but not least, is entertainment and TV. And you might immediately in your mind go to Xbox, and I don't want you to immediately in your mind go to Xbox. At the end of the day the real opportunity here is having a device that sits next to or in every television set. I like thing where you can say PC times dollars per PC. Phones times dollars per phone. I dream of someday when I can talk to you about TVs times dollars per TV. You can attach a PC to a TV, that's our Media Center concept. You can put a console next to a TV, that's the Xbox concept. You can put a set-top box next to a TV, that's our Media Room concept. There could be new appliance devices that we or others design that sit next to a TV, that could be part of the equation. The TV could be connected via a private network, like Comcast does today, or AT&T does today. In AT&T's case, it's a private IP network. In Comcast's case, it's not. But increasingly it could also be attached to the open Internet. I don't know about you, I actually watch some of my favorite TV programs not on the TV, but on the PC, because it's the simplest place for me to go get back episodes of Lost, for example. We're bringing our services, our gaming service, and our Zune Service, not the Zune hardware but the Zune Entertainment Service, to all three screens, PC, phone, and TV. So it becomes a fundamental part of building a real business around TV sets. I didn't know who to compare with directly. I show you some Nintendo numbers because we look at them. In the short-term, here I didn't talk about revenue realization, I actually talked about gross margin. There's always work underway, and there is today on reducing the cost of the Xbox. One of the best ways for us to improve revenue is to get better attach of paid subscriptions to Xbox. Game attach could be a challenge. If we learned anything last Christmas, it's that people will continue to buy the Triple A title, but they may not buy the second or third title in a challenged economic time. And we keep expanding the number of operators with whom we're working on our Media Room set-top box software. Eastern Europe, Russia, AT&T of course here in the U.S., Singapore, that footprint continues to expand, and that's a very good gross margin business for us, 100 percent essentially growth margins as we expand it in this world.
  • 15. I'm just going to wrap up with a few summary comments. Seven areas that I think are the right things for us to invest in with the supporting cast of businesses that are at least breakeven or profitable; a right-sized enterprise overhead; and a sensible, 3 percent, investment in research and incubation. That's how I characterize the right opportunities. If you say to me, hey, can $27-1/2 billion be $20 billion? I would tell you it would be imprudent. Could $27-1/2 billion be $27 billion or $28 billion, sure, it was a little, you could say, arbitrary, although I spent three weeks at Christmas, because of the way Christmas and New Year laid out, there was basically nobody at Microsoft for almost two weeks, which depressed me in a certain way, but the way the holidays laid out people took the time off, and I spent the time with Chris just going through, going through, going through the OPEX, really trying to decide what I thought was sane from an investment perspective. We had just finished our annual strategy review process in December. We really took a look at the numbers, and I think this is right. I don't think it makes sense for us to go back and say, hey, could we take out another $2 billion of cost. I think we have done that. W worked hard on it to come up with these numbers. You could always take out more, I could always put more in. And some people say, well, what if the economy is worse? I'm telling you, we've got a view that the economy is going to be relatively weak for a relatively long period of time. On average, I think I probably think things will be weaker longer than most people, and I know I have continuously thought that things would be weaker than most of the people I talk to. And yes this is what I think is the appropriate level of investment. We are going to manage the costs intensely. We are usually pretty good at delivering on the cost targets that we set for our people, but I think we still have more costs we can go look at and take out between revenue and gross margin. That's still an area where I think we have opportunity for improvement. We're going to compete for share, that is economy independent, and the theme I'm sending to all our people is share, share, share, share, share. The one antidote to all issues, it's the one thing we can absolutely control, but let's go get share with good -- I call it revenue realization, because it's kind of revenue per share point. It's not price, and it's not absolute revenue, it's the revenue that we can realize from a point of share. Last, but not least, we're going to engage in what I decided to call careful cash management, careful, careful. You know we like liquidity, we like it more than we used to. We liked it more than you want us to like it. We like it more than we used to. On the other hand, we've had a consistent dividend policy. We have tried to scale the dividends to operating income. You should keep that in mind. I know our board will the next time we have the discussion, which won't be for seven or eight months typically I think we tend to do it once a year. And we will be cautious. We're not saying anything about buyback, I'll just say we're going to be cautious and careful overall in our cash management. And that's how we think about our business in this market, this economic environment, and this market environment. So with that I'm going to wrap up and we'll open up for questions and discussion.
  • 16. BILL KOEFOED: So I realize that we're over on time, and I realize that some of you may have to leave, but for those of you who can stay we'll have time for two questions. So who has the first question. STEVE BALLMER: We'll take a few questions. BILL KOEFOED: How about in the back? JOHN DIFUCCI: Steve, it's John DiFucci from JP Morgan. Just a question you mentioned customers for netbooks willing to spend a little more for the value. Are you talking about something a higher price than the Windows XP basic that you have on netbooks today, or are you talking about that price point? STEVE BALLMER: No, look, I think we have an opportunity when we ship Windows 7, which will fit on a netbook, we have an opportunity to rethink the product lineup for netbooks, product lineup and price lineup, and we get a chance to engage in that dialogue, both with the OEM, and potentially with the OEM and the end user. Today when you buy a netbook with XP you don't really get a full XP version, you get some restrictions on XP. Some people might say, hey, look, I'm happy with the restrictions, some people might want Windows 7 instead of XP, some might be happy with the restrictions, some end users might not be happy with the same restrictions. I think it's important for us, we have some time before we are actually in market, and as we have more to say you'll hear it, but we have a real opportunity given that Windows 7 fits on netbooks, to think about having a special netbook edition, but maybe somebody will want home, or maybe somebody will even, for example, want the business edition of Windows 7 on a netbook. I want to make sure we facilitate letting the customer, OEM or end customer, trade up if they want to trade up. JOHN DIFUCCI: I'm sorry, that netbook edition of Windows 7, would that be at a different price point than the current XP edition that's on netbooks? STEVE BALLMER: We will continue to have a netbook product at the current Windows XP price point. The question is, what other price points will we have above that, and how effective are we in trading people up. I think it's important that we maintain an offer at the price point that we have on netbooks today. But, give the OEM and the user a chance to trade up from there. JOHN DIFUCCI: Okay. Thank you. QUESTION: Steve, you're spending the least amount of CAPEX on the mobile business, of operating income, OPEX sorry, versus now you're doubling down more on Windows. Can you talk through the tradeoffs as you look at the mobile market rapidly growing, and we're taking more notes on our mobile phones than we are on our laptops, and how do you think about the trade offs on that business?
  • 17. STEVE BALLMER: Well, the number I actually showed on the first -- on the top slide I showed you the specific breakouts. On the first Windows slide I actually showed you the union of Windows and Windows Mobile, compared to Apple, compared to RIM, because I think that's the right way to think about it, that's the way we think about it. There will be really shared technology across Windows and Windows mobile. The browser is an example, the presentation surface is an example. Some day even the kernel will be an example. So I think of that as a continuum, it's two different business models, actually. The business models are somewhat different. The competitive dynamics, because of the operators, and the different device manufacturers are different, but at the end of the day the technology base will be largely shared over time, as opposed to historically where it was largely not shared. I was going to tease you and say, if you weren't carrying that Mac you'd probably take more notes on your laptop, but I won't make that comment. QUESTION: Can you just talk a little bit about your retail store initiative, and what some of your objectives and motivations are? STEVE BALLMER: Let me first say that when we have a real, complete plan we'll tell you what our real complete plan is. The fact that we hired somebody, David Porter, and David is going to be out talking to people, meant we knew that our intent was going to leak, so we chose to disclose it. But we have a real, professional, full-time focus in on this now, and exactly what we'll do, and where we'll go -- we don't intend to dig some big economic hole with our stores, let me say it that way. So I feel pretty comfortable about having the discussion in the context of this meeting. But exactly is that going to be a few stores, a lot of stores, how many, where, what products, we will have to carry product that's interesting, which means more than Microsoft products. We're going to have to carry hardware that runs our operating systems and the like, and we've had some discussions with retailers, and with OEMs about this, but there's still a lot to be worked through. David is now one week with Microsoft. It might take him more than two weeks before he feels like he's got the plan, but he definitely is off to the races, and I've known David for a while, through both Wal-Mart and Dreamworks, and Kevin Turner has known him for a while. And I think we'll fairly rapidly get to a meeting of the minds on what we should try to do specifically. I have some ideas, but we really have to give David the chance to build his own ideas, kind of. ADAM HOLT: Thank you. It's Adam Holt from Morgan Stanley. Understanding you've got very limited visibility on IT spending in general I wanted to get some maybe preliminary thoughts on how you think about the corporate upgrade cycle for both Windows 7, and also Office 14, in particular the extent that people are pushing out PC upgrades on the corporate side, how does that cause you to think about the cycle-on-cycle
  • 18. upgrade potential for Windows 7? Does that mean there's some latent demand potentially, or do you think about it as really delaying the upgrade cycle? And what can you do on the enterprise licensing side that may incent people to be more aggressive on the licensing front? STEVE BALLMER: Well you have PC upgrades then you have people's willingness to license software. It's all part of enterprise IT spend. The fact of the matter is our annuity customers are licensed, our Windows annuity customers. The non-annuity customers primarily will upgrade by buying new PCs. That's a historic truth. Most people do, in fact, choose to get a new PC when they upgrade the operating system. It is the minority who upgrade the operating system in corporations without getting a new PC. So in both cases we are somewhat dependent on PC sales cycles, and I think, as I've said, everybody has got to go do their own thinking, modeling, economic analysis to try to come up with a view on that. I think we have a pretty good product. I think we have some pent up latent interest, as people have been testing but not deploying Vista. But we'll have to see. QUESTION: This is a strategy meeting, so don't shoot me on this question, but out there you see trends towards virtualization and mobilization, and -- I'm sorry, mobility, and I'm just curious how you think about, or how committed you are long-term to the licensing model for Windows that you have, versus a moving towards maybe not open source, but something away from that? You have a puzzled look on your face. STEVE BALLMER: I think what you're asking me, you're basically -- let me say why I look puzzled. You're basically asking me will I take our something -- what's our reported client segment revenue? You're basically asking me would we take something for which we derive $14 or $15 billion of gross margin and make it zero. That's the way I'm reading the question, and I'm sort of sitting here saying, I don't know really how to answer that, because if I say no you think I'm a troglodyte, and if I -- I mean, if I say I won't do I'm a troglodyte and if I say I will do it I think everybody else should walk out of the room. So I'm not trying to push back, I'm trying to understand what you're really asking. QUESTION: Well, I guess you see the virtualization strategy out there, and you see that there is definitely a move towards mobility, and I'm not asking you to take away the big cash flow cow for you guys. But I'm just curious how you think about that longer-term, because I know you talk in your meetings about thinking out a year, five years, 10 years down the road, and this is a big question I think on a lot of people's minds, as we see all these things happen. So I was curious what you thought. STEVE BALLMER: Let me see what you're saying. I think what you're saying is, if computation is either going to move to the cloud in some virtualized model, or if computation is going to move to something that's a notebook disguised as a phone instead of a notebook the way it's disguised today, what do you think and what are you doing? If things move to the cloud my answer is still, we license users.
  • 19. We need to have a way to -- if we're not delivering value to the user, we've got a problem, whether we happen to collect that value per user as a royalty on a piece of physical hardware, or a service that's delivered either out of the customer's data center or our data center, we need to have enough value that somebody says, hey look, I feel good about the fact -- I think you guys think our average royalties are $50 to $100. So let's take the business case, because that's where virtualization might happen and say, do we offer $33 per year of value per user for Windows. We have to make sure that we can maintain or enhance that value proposition. That's a challenge I feel pretty good about. If you flip it around and say, okay, what if some day people just carry with them a brick, and the brick can be a phone, but when I lay it down next to a screen it's a PC, and to the gentleman's question or comment earlier about phones and PCs, they could come to be more similar technologically over time. So if somebody wants to carry a brick with them that they make phone calls on, and then they throw it in a little dock, or they set it down next to a screen and there's a Bluetooth connection, and it has Excel on it, and runs their full desktop, I need -- Microsoft needs to offer enough value to license the brick, and have the brick be a valuable brick for our company, our shareholders, and our customers. So we're prepared for those two eventualities. That doesn't mean we're racing to get the world to virtualize. I'm actually not even sure that's what the world wants. And I think it will be a while before people say they really want to have one device that is both their phone and their PC, because there's just too many tradeoffs in the short-term. But, in the long-term, can we have either virtually or physically something that we license that we get economic value from, that the user gets a benefit from, that brings in the kind of revenue that we expect out of clients? I think we have a great opportunity to continue to grow with the market there. BILL KOEFOED: All right. Let's make this the last question. STEVE BALLMER: I'll take those two, there are two hands up. The two hands that are up on the aisle. QUESTION: Just a quick question about the Microsoft acquisition strategy, or consolidation strategy considering the dislocation in the market, the recessionary times. Has there been any change, and how do you come out of this stronger via acquisitions? CHRIS LIDDELL: There's no essential change to our attitude, which over the last few years has been acquisitive, as you know. We've acquired a particularly large number of companies in what we've described as the small to medium-size category, tens of millions of dollars, or occasionally hundreds of millions of dollars. So there's no essential change in attitude for that. I think there's clearly been a change in firstly the pricing, but secondly the willingness of people to sell at that pricing. So ironically it's likely to be a relatively slow period for the next, let's just say, 12 months for the sake of discussion, simply because haven't already set their expectations around current values versus what they would wished for a year ago.
  • 20. So we are still acquisitive. We would still do transactions, if we can find them, that make strategic and financial sense, but it's likely to be a slow period, just because we're finding vendors aren't willing to reset their expectations. STEVE BALLMER: Even small acquisitions do require OPEX, and if they have enough additional revenue I guess you can make them, but otherwise we'll watch them perhaps slightly more tightly, because we don't have a ramping OPEX curve the way we have the last several years. Way in the back. SCOTT COLEMAN: Hi, Scott Coleman, Credence Capital. The first question is, on the netbooks going forward what do you take out of the OS or hide in the OS to get it down to something that can be cheaper that you want to put into it, or less expensive for the end user that you can put into a netbook? And then, secondly, also what are you going to do with the technology? It seems like there's this constant struggle, always has been, between stolen licensing and what you collect revenues on, it seems like you come out with something new to keep people from stealing it, and then they come up with a way to get around it, and then the circle goes around and round. Where do you see that going in the future as things get more connected, do you see an end game here? STEVE BALLMER: As things get more connected do we see -- QUESTION: An end game to stolen licenses? STEVE BALLMER: No, I don't really see an end game any time soon to pirated versions. The truth of the matter is, the harder you make it for somebody to copy, the harder you also make it for a legitimate user. So there's a tension, there's a real tension between the two, and the pendulum does swing a little bit, but if we try to lock things down, it makes life tough for the legitimate user. And if we lock things not at all, we have some issues. I don't see that, let's say, end gaming. In terms of the netbook, if you want a big screen, you can't buy our netbook. If you want a decent-size screen by most people's standards, the netbook pricing does not apply. It only applies to smaller screen devices. I think it's 10-inches and under at this stage. You can only run a certain number of applications at a time. Some of this is by technical enforcement, some of it is by licensing, but the Windows XP SKU is actually a SKU that only lets you run machines essentially of a certain capability and software of a certain capability, and you ought to expect us to continue to have a set of technology and licensing restrictions that distinguish even in a Windows 7 era the capabilities of PCs running various Windows 7 SKUs. BILL KOEFOED: All right. Thank you everybody for coming today, really appreciate your time, and have a great day.
  • 21. END