02262009 Goldman Sachs Chris Liddell


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02262009 Goldman Sachs Chris Liddell

  1. 1. Who: Chris Liddell, Senior Vice President, Chief Financial Officer When: Thursday, February 26, 2009 Where: Goldman Sachs Technology and Internet Conference 2009 - Las Vegas, Nevada SARAH FRIAR: Okay, everyone, if you wouldn't mind coming in and grabbing a seat, we're going to close up the doors and get going with our second keynote here with Microsoft, if I have any impact on the room. Okay, great. Thanks, everyone. So it's my pleasure to have on stage with me Chris Liddell, the CFO of Microsoft. Chris, I know you've been back on the East Coast, so I appreciate you making the stop off here on the way back to Seattle. So as I talked to you about, as we walked in here, I was thinking of all sorts of different ways to start this conversation, and it seems a little trite to ask about the environment, but that's where I'm going to begin. So when we get Microsoft up for keynotes, what I think is so great for an audience of even non-software investors is you have such a broad global purview. So if I could get you to just kick off our talk a little bit about what you're seeing, particularly demand trends, clearly they slowed in the back-half of last year, and any color that you can give us incrementally at this stage. CHRIS LIDDELL: Yes, sure. And why don't I start by talking a little bit about where we are at the moment, and then I'll talk a little bit about how we see the future. Where we're at the moment is really what everyone sees on a day-to-day basis. It's just a very tough environment everywhere. I think the thing that differentiates the environment at the moment relative to anything else I've seen is just how broad it is. So pretty much regardless of the geography that you go to, regardless of the segment that you go to, or regardless of the product that you're talking about, it's just a tough trading environment. So here in the U.S., clearly, in Europe, places like Russia are very difficult, even China is slowing down. Small businesses, medium-sized businesses, large businesses, it's just an incredibly tough trading environment, certainly the worst that pretty much any of us have seen in our lifetimes. The key thing then becomes, okay, that's where we are at the moment, what do we look forward to? SARAH FRIAR: Right. CHRIS LIDDELL: And all of us have become, interestingly, historians over the last three or four months as we try and figure and navigate the future; we try and get a sense of what can we learn from the past. And where I started, just from a macro point of view, and again I'm not an economist, I'm not a forecaster, but it's interesting when you read about severe contractions like this, in particular ones that are triggered by credit issues, and you look back, say, over 150 years. I read a report the other day that looked at 15 similar ones in North America and other geographies, and generally speaking the GDP contracts by on average 10 percent. It varies from 3 or 4 percent, mild, to the Great
  2. 2. Depression which was 30 percent. Those are our outliers, but on average it contracts by 10 percent. Now, that's not a forecast, but it's not unreasonable think - on the scale of what we're talking about - that we could see GDP contraction on a global basis of that sort of order to magnitude. Certainly 5 percent - we're seeing in places like Japan, you're already seeing a run rate of more than 10 percent. So in our thinking and our mental planning, we aren't necessarily saying that is the issue. For the first time we did some serious scenario planning because of the uncertainty in our strategic planning process that we went through in December, but in terms of the mental model of the world I have, a contraction of some substance is the way that we're thinking about it. And Steve talked about things in terms of a reset. SARAH FRIAR: Yes. CHRIS LIDDELL: So I would say we've been through a period of obviously very good growth, certainly over the last decade, both as an industry and as Microsoft. I think we're now going through a reset period, or contraction, and then I think we go back to a growth period. How long the contraction is going to be and how deep, none of us know, but it's certainly going to be for the foreseeable future, the rest of our fiscal year, probably for the balance of this year, and despite what politicians and others are saying, it's probably the next year or two we're going to see a difficult trading environment, and then growth, but probably growth at a lower rate than what we've seen in the past, because I think we're all realizing that some of the growth that was inherent in the last decade was artificially inflated by the credit issues that we're now having to take out of the system. So growth, contraction, growth at a lower rate is our sort of base case when we think about the world. And the issue then becomes, in that environment, none of us knows how deep for how long, but then in that environment what's the appropriate way of running the company, and how do we change our thinking from where we were, say, even a year ago but certainly in the last decade. And the big things for us are, there's five key things that I think will differentiate companies in this environment. Clearly the water level is going up for everyone. Everyone is going to be impacted. That's not a Microsoft statement; it's a general economic statement. And so the five key things from my point of view that will differentiate companies are market share, because clearly regardless of what the market does you're still able to take or lose market share to your competitors. So our ability to take market share has become much more of a focus. How much we get - what we describe as revenue per unit of market share. So in particular, for example, the enterprise space where we, like everyone else, are seeing pressure from people trying to cut their IT budgets: can we add more products to our enterprise suite, can we differentiate ourselves in a way where for that level of economic unit of market share, can we drive more revenue, or mitigate revenue losses.
  3. 3. Third, there's obviously cost containment. And we took a view, as you've seen, that we would keep our costs essentially flat for the foreseeable future. Other people have taken a more dramatic approach and actually cut costs. Other people are still probably grappling with what the environment looks like, and what the appropriate response is. From our point of view, relative to growing our expenses at 10 percent plus for the last five years, because we've had the benefit of revenue growing by that amount, we're now decelerated to a flat environment, and that's, from our point of view anyway, the right balance in this environment, although, again, a lot of the discussion over the last few weeks has been whether that's enough, which I can go into more. Cost containment, prioritization, so the natural adjunct to cost containment is you spend a finite amount of dollars, where do you spend it? And we have become much more focused and systematic in our planning process in the last couple of months about prioritizing projects, cutting some projects, slowing others, and funneling what resources we are going to spend into the highest, most strategic and highest return area. Last but not least is cash management. So we're in an incredibly fortunate position of having a lot of cash on the balance sheet, AAA rating if we were ever to raise any debt. So how we manage our cash in terms of either building it, or utilizing it in this current environment relative to others, whether we spend it on acquisitions, whether we spend it on dividends, whether we spend it on buy-backs, how we manage cash over the next couple of years, given that cash has become about 100 percent more valuable than it was a year ago, is a pretty big differentiator, as well. So those are the sort of five levers that I think will differentiate companies in what we think of as a very tough environment. We aren't saying whether GDP is going to go down by 10, 5, 15 [percent], it's sort of irrelevant in an environment like the one we're talking about. Those are the things that we have to focus on. SARAH FRIAR: That actually lays out a nice roadmap, I think, for our conversation. So if I start with market share, or where you think Microsoft can find growth right now, what are the areas you're most excited about, and as you think about that investment, that three-five-year investment; what are going to be the big levers that can really shift the needle for a company of Microsoft's size? CHRIS LIDDELL: Certainly over the short term in the enterprise space, we just think our offerings are fantastic there. In the server and tools area, which is a basic Windows Server offering, SQL Server in particular, and some of the total cost of ownership opportunities that we have to offer, so offering a product that saves people money, the virtualization capabilities. So we think a basic enterprise offering is fabulous. And then Microsoft Business Division - similarly all the things that are an adjunct to Office, things like SharePoint are still growing extremely well in a difficult environment. So you can still find pockets of growth in products there where CIOs still see a productivity advantage even in this area.
  4. 4. So in the short term the enterprise space, I think, is where we can differentiate ourselves. In the medium to longer-term, clearly the online area, which we'll come to at some stage [in this discussion], is a huge area of opportunity to us. And also in the medium to long- term moving to the cloud, so a lot of the work that we're doing with Azure, which will be a slow ramp, but in terms of a five-to-ten-year picture, we think from an economic value point of view [that] it's still a huge opportunity, even in a difficult environment. SARAH FRIAR: Sure, and that's kind of a good mixture of the infrastructure you talked about in the beginning, and then apps on the front end. CHRIS LIDDELL: Yes. SARAH FRIAR: In the near-term, if you kind of look at product cycles, tech is somewhat devoid of product cycles right now, which is odd, because that's what our industry has always been predicated on, but Windows 7 is kind of hitting people's radar screen off and on. It seemed to gain a lot of attraction in the last couple of weeks all of a sudden. How much could Windows 7 move the needle for Microsoft as you think about perhaps a launch towards the back end of this year, and then looking into next year, both consumer, and then clearly enterprise is always a little bit more lagging. CHRIS LIDDELL: It will help, but I always temper expectations by saying macroeconomic conditions really dominate things. They dominate any product cycle, and they'll dominate the PC cycle, as well. Could we see a slowing of the PC sales this year partially in anticipation of Windows 7? That's possible, and so we might see a bump next year just as a result of lower demand this year. So that could certainly help. Upgrading … we typically get an upgrade, so some bump in revenue, but that's measured in the hundreds of millions, not in the billions. And certainly the experience is extremely good. All of the feedback we've got, which I'm sure you've seen through blogs and people using it, has been extremely positive. So I think that will certainly encourage people to the extent they're a marginal buyer of PCs … encourage them onto it. So it will be helpful, but it won't outweigh the general macroeconomic conditions. SARAH FRIAR: Yes, kind of my old phrase is always macro trumps everything. But as you think about the enterprise, which I realize, irrespective of if you launch end of this year [or] beginning of next, enterprises still probably won't look until 2010, by nature of their upgrade cycles. Do you have a sense, though, that there is any pent-up demand building, because Vista didn't get the penetration that I think you would have hoped for off a new OS. And in particular, as you think about large enterprises, who are probably on SA so it may not matter, versus a mid-market who may have gone dark, and aren't on a kind of ongoing maintenance program, how do you think those two could trend, as you think about an OS rolling out?
  5. 5. CHRIS LIDDELL: I think there's some pent-up demand, but again, I wouldn't oversell it. I think that this year will just be a difficult year. When most CIOs of large organizations, or CEOs of small and medium organizations look at the discretionary spend, something like a PC is probably something they're going to say, well, let's just extend the life out six months. That's a decision that I'm sure a number of people will take, and that's clearly going to impact PC sales this year. But, at some stage obviously that catches up, you extend the cycle and it comes back. So I think there will be pent-up demand as much because of the macro factors that I'm talking about as anything that's to do with Vista. So people may have been holding back in anticipation of Windows 7 from as long ago as six months ago when people started to see what the shape of the calendar might look like. Then we've got the macro-overlay. So I could certainly see a relatively weak enterprise situation through this year, which rebounds next year when we see Windows 7. SARAH FRIAR: In terms of Windows 7, I mean, one part -- one big piece of the feedback on the beta test has been the rearchitecting of the kernel has made it much more lightweight. So your point about a hardware refresh cycle, normally I would say absolutely, no one is going to buy a new OS without doing the hardware. Are you pushing more for folks to think about maybe keeping hardware in place, and literally just lifting the OS perhaps more than normal, or how do you think you're going to -- CHRIS LIDDELL: We aren't pushing that. Certainly people are talking to us about that, and the ability, obviously, to overlay. Now, from our point of view, it's fine if they want to buy a license that's good news, even if they do it independently of the hardware, and so we may see a -- SARAH FRIAR: On the enterprise side. CHRIS LIDDELL: Yes, we may see some benefits from that, but it’s not something were pushing. SARAH FRIAR: And I would think with consumers OS really has to come with new hardware. On the hardware side, the other kind of controversial point is netbooks, which kind of crept into the vernacular I think two quarters ago on Microsoft's call, where suddenly we saw this outsized growth rate from netbooks. Talk to us a little bit about the implication, particularly ASPs, and then ultimately margins, if we're moving into a world of much lower-spec type PCs, lower price, how can Microsoft really maintain the level of pricing and the margins that you've had? CHRIS LIDDELL: The first thing to say, it's a phenomena that really crept up on all of us. We weren't talking about it as you say -- we wouldn't have talked about it certainly a year ago. And they're now something like 10 percent of the market. So they are an extremely important trend, in particularly in a difficult economic environment where their low price point makes them pretty attractive.
  6. 6. We see it clearly as part cannibalization, clearly it's also part new category. I would argue with anyone that PC growth wouldn't be as high as it has been without netbooks. So there's clearly an element of some people are buying a PC rather than another electronic good, because of the price point, as opposed to trading down. So part cannibalization, part new category. On the part that's cannibalization, the challenge for us, clearly, is to try and get the ASP up. And we haven't announced the pricing structure of Windows 7 - it certainly won't be today - but we see it as an opportunity. We'll still clearly have a basic SKU, which works on netbooks and I think we've already said that Windows 7 will work on netbooks. So we'll have a basic SKU, but we'll also have the ability for people to trade up and get a better SKU [on netbooks], which would give us a price more similar to what we'd normally get for a consumer. So, again, this is all in the workings at the moment. We haven't defined exactly how we'll do that, but it's an opportunity for the cannibalization part of it, to try and get people back to the sort of level that we would hope to get from a normal consumer PC. On the part that's new category, that's starts to introduce some exciting new opportunities. And the question is how, at a relatively low price point, sub-$300, how we can help the device manufacturers drive an even greater growth rate. If it's a totally new category, it's a marginal sale that wouldn't have happened otherwise. It's fantastic. We may not get, obviously, a lot of price, but still effectively -- SARAH FRIAR: It's all money in the bank. CHRIS LIDDELL: Yes, 100 percent margin business that we wouldn't have otherwise got. And that starts to get really interesting in terms of the opportunities to connect to TVs, connect to projectors, have devices which have intelligence in them, have a Windows Operating System at a lower price point than traditional users of a PC. So, again, those are early days for both of those. That isn't going to be transformational in the next financial year, but I think netbooks is as much an opportunity as it is a challenge in terms of degradation of the ASP. SARAH FRIAR: Fair. And then attach rates I think are also worth commenting on, because if we look in the summer attach rates were at the 25-30 percent type range, today they're 85 percent plus. How do you think that evolves, though, as you get maybe a Google Android device that's kind of part phone, part netbook - mid-type device. Maybe you get new chipsets coming out from Qualcomm, so today's kind of Intel's game which is you, how do you think that dynamic shifts over time? CHRIS LIDDELL: It's got to be about the user experience. And we still have the view that the basic Windows experience, and this is what we found, one of the reasons why we got the attach rate, as you say, we're almost zero to start with to 20 percent and now above 80, is that people are willing to pay an extra $20 or $30 to have a fundamentally good experience. In the overall scheme of a device that you use virtually every day for
  7. 7. three or four years, if you amortize $20 or $30, even in difficult economic times, most people would say that's a tradeoff that's good to get the basic Windows experience, plus all the applications that you get on top of that relative to a Linux experience. And even an ARM Android combination, we still say there's a basic experience that we're happy to compete on that we think there's an economic tradeoff that people are willing to make. And to my point before, yes a $20 or $30 experience is probably a $50 experience that we could offer people, but again at the margin you say, I guess, not for everyone, but in the overall scheme of something amortize that, it's $5 to $10 a year more, it's not an enormous amount of money. What we have to do is convince people that the product quality and the experience are good enough to make that economic tradeoff, rather than just simply drive the price down. SARAH FRIAR: In talking to experience - kind of where we go with these very connected devices, computing sucks back into the cloud - talk a little bit about that shift for Microsoft, because the other pushback I get is, you get the very thin clients that don't need a lot of software deployed at that end point. So you do get the shift of your kind of Office productivity suite type apps on the device back up into the cloud? That has ramifications both for, does a market share shift occur, because you've really owned that, but now maybe other competitors can start to make inroads finally. Google Apps, for example, is probably been the one the press has talked to most. Then as the CFO it has ramifications for how you'll get revenue over the long run, maybe more subscription rather than up-front payments, and so on. CHRIS LIDDELL: Yes. There's a whole range of things here you just said that we can go into. Client virtualization is as much an opportunity for us as a threat, absolutely. In fact, [for] the products that we offer in the client virtualization space, we charge as much with the management associated with them as we do for the underlying PC-only client experience. That will evolve, and we need to actually have a product suite that is the full range from basic Windows experience to a client being virtualized, and I think that actually we're in remarkably good shape for that. In terms of shifting into the cloud and the services there, again with the Azure strategy that we have, I think we will differentiate ourselves. Other people will do it as well. But one thing people can be confident on is that Microsoft will do it at scale, and do it extremely well, and do it extremely reliably. There aren't many companies in the world that are going to be able to do it at the scale that we are, or with the long-term commitment. So if you're a developer, we have an extremely good proposition. If you're an enterprise, we've got an extremely good proposition, because you know if you port something to us it's going to be available for the next 10 years, and 20 years. So moving to the cloud, again, as long as we have the right products, is a good opportunity, not a bad one. In terms of the economic model that forces, which is the end of your question, that's a whole different thing again. But, I think that's probably positive on balance. We will
  8. 8. obviously lose some license-only sales and turn them into annuities. We are in the fortunate position where cash flow is not the biggest problem that we have. SARAH FRIAR: Right. CHRIS LIDDELL: So if we get paid over time rather than paid up-front, as long as the present value of the economic streams is at least equal to or greater than that, then that's a benefit for us. If we can get into a client relationship where we have an annuity stream as part of an overall relationship with Microsoft where we can up-sell that over time, that's the actual economic model that's worked fantastically in the last five to ten years in things like the Server and Tools business. SARAH FRIAR: Yes. CHRIS LIDDELL: So we may lose some accounting up-front, I don't think we lose economics, because at the end of the day I think we're just going to be amortizing the software costs over the life of what we're talking about, plus adding a margin for the hosting aspect of it. If we can do it at scale and do it efficiently, clearly there's an economic benefit relative to hosting inside the corporate firewall that we'll share with our customers, but there should be an uplift in economic value creation albeit over time. And then it's all about pricing structures, and being competitive with other people, but we should be able to do it at scale such that we should be the most competitive from a cost point of view of anyone in the world. SARAH FRIAR: For sure. I think both deep pockets to build that scale, and then as you said hearts and minds of developers, I think are probably the two factors. And there are not that many companies that can back up on those factors. To switch gears a little bit, I just want to be mindful of time, I want to shift to the online services business. In the grand scheme of where Microsoft today gets its revenue and profits from, it's clearly small on the revenue side, and then it's kind of a great big whopping negative on the profit side. But, as you've talked to me about many times, you're looking for things that can move the needle over the long run. Talk a little bit about how that strategy is evolving, and perhaps the question I get most often is, given the downturn, would they just pull back on the investment here, because it's so in the red, isn't it something that they could begin to ease back a little on? CHRIS LIDDELL: Well, start with the big picture and then move to the specifics of what we're doing. The big picture is important from two points of view, in my mind. Firstly, the economic value prize is still as big as it ever was in online advertising. It's certainly, when you look at the growth rates, they're not as high as they were, but this will be an industry that's going to be $50 or $60 billion of revenue in the next few years. It might not be in the next three, as we thought a year or so ago, but it's going to be in five or six years. SARAH FRIAR: Sure, so it can actually move the needle for Microsoft.
  9. 9. CHRIS LIDDELL: So the size of the economic prize is high. I think we're all learning about where the pockets of economic value are going to be created inside that revenue. And when you look at what's happening on the display side, you have to say that's getting more difficult over time. But I think that the fundamental thesis about economic value created on the search side is still intact. So for our point of view, in terms of things that can move the dial and things where there's a large amount of economic value, and things where technology and software will be a differentiator, that's still absolutely intact. So the offensive side of being in search still makes sense. The other big thing, coming back to being a study of history, when you look at difficult periods, and you look at the companies that have prospered in the difficult periods, they have generally caught the few small waves that continue to be trends that are positive inside a negative environment. And from our point of view, online advertising is still going to be a relatively positive trend over the next five to ten years. Some relatively large proportion, the $600 billion spent in advertising is just going to shift online because of all the fundamental benefits of it, albeit maybe at a slower rate than what we saw before. So we still think the benefits of being there are the same. They may not be as high on an instantaneous basis, unfortunately the revenue growth we're going to see, and the revenue growth all our competitors are going to see in the short-term isn't as high, so we're going to suffer economically more than we would have otherwise, but there's no backing off of the fundamental strategy. Where we are, we went through a cost reduction program over the last few months, and we cut online just like we cut all the other areas. There are some things which we just don't see as strategic, for example growth in Europe. Launching our Cashback Program in Europe, which we had in the plan for the next year, doesn't make as much sense in this environment. SARAH FRIAR: They need all the cash they can get, right. CHRIS LIDDELL: Yes. There are some things that we will cut back on at the margin, and that was part of the $1.5 billion that we would have otherwise spent this year that we're not going to. The drive to getting parity on algorithmic relevance, the drive to getting a great product suite, the drive to getting incredibly good search products is still as high as ever. And the thing that we have now is [that] we have the strongest team we've ever had in that area. SARAH FRIAR: Right. CHRIS LIDDELL: So it's obviously public that we hired Qi Lu who used to work at Yahoo -- fabulous guy, made an impression already. We've hired some other very good people. We've shifted talent into the area that we didn't have otherwise, and I think one of the things that we haven't done well is having our top talent in that area. In particular as we were getting through Vista, we had a lot of our top talent focused in the client and enterprise side. We're getting a lot of our internal talent there [in Online Services].
  10. 10. We've made some great external hires. So we've got the right people, we've got the resource, and we've still got the fundamental drive to do something there. SARAH FRIAR: So I mean, I guess from the outside in, the frustration is, Microsoft with all this huge cash balance to come at this with, and clearly a lot of focus on it, you've gotten probably to a point where I think most -- when you talk to the experts out there, it's technologically there, so the right algorithms, you're coming on par with a Google. But no market presence and I don't mean that in an insensitive way. But what is it -- it sounds like it -- what is it that tips you over, and is the only answer doing something with a bigger partner like Yahoo, for example. CHRIS LIDDELL: With whomever begins with Y? I wouldn't dispute it. No one inside Microsoft is saying we have done as well as we should have from a market point of view. Clearly we haven't, we haven't made the inroads that we would have liked to. I would be as critical as anyone inside the company of that. And there is no silver bullet. We have to do, and we have to have a plan that excludes Yahoo. We can't be dependent on that. I'll come back and answer your Yahoo question, but from a fundamental point of view, we have to do a broad range of things. We have to – obviously. I don’t think we are there on the algorithmic side, or on the technical side. We're certainly approaching it, and our learning curve is steeper just because we're coming off a lower base, but we're not there yet. So we need to continue that side. We need to try different things, like a different economic model like Cashback. We need to do distribution deals to bootstrap user demand. We have to think about things like a new brand, and marketing that. So we have to do a variety of things, and we have to continue to surf the innovation wave, because there are going to be some things that happen that we just don't even think about at the moment over the next three to five years. So we need to do all of that. It is going to be, and we qualify it, it is going to be hard yards. It's going to be a percent here and a percent there. We have not been able to achieve that in the past, so that in its own right would be a significant step forward if we can start to drive market share in the way that we haven't, which is the fundamental measure at the end of the day of whether we're going to be successful or not. SARAH FRIAR: You've put a lot of money into the technology build, the brand, is there a plan to come at it from brand awareness? I always poll my investors, do you know where to go to search on Microsoft, and Live.com doesn't ring a bell with anyone. CHRIS LIDDELL: It hasn't. It obviously hasn't the made inroads. So when I talk about a new brand, that might be something that we have to embrace. So, yes, brand awareness is one aspect of it. With respect to Yahoo, what we've always said is, it's a good increase. But in its own right, it won't solve all of these issues in its own right. Putting the two forces together, actually, ironically, is about cost reduction as much as it is about market presence. The
  11. 11. power of the outsourcing deal that we've talked about relatively publicly is that we have a massive amount of shared infrastructure, and cost going into the same areas. By pooling our resources, we can collectively save an enormous amount of money, so that the economic driver is actually a cost in the short-term. In the medium to long-term, clearly scale has some benefits. So scale helps us, but it doesn't in itself change things either. Yahoo's presence is fine, it's been deteriorating somewhat, it's stabilized recently, but they don't have the magic solution either. So putting the two organizations together would be an incredibly useful step, but it's certainly not a panacea, and we don't see it as a panacea. And even though we've suggested it would be great to get together, we don't work on the basis that it's going to happen. If it does, that's great, but if it doesn't, that's fine, too. And obviously we've tried for a year and it hasn't happened, so it may or may not happen, and no one should think that suddenly will transform the industry in a way that is anything other than a useful additional step. SARAH FRIAR: Fair. In the interest of time, I want to switch to kind of below the top line into the cost side of the equation, probably a little bit more fair ground for a CFO. You talk a lot, well Steve has actually used that phrase about a resetting to a new level, and it resonates with me because it's how we think about our business within Goldman as well. But to that end, we've said, if this is the resetting of our business, to kind of '02-'03 levels, we will reset our headcount, which is really our cost, to that level. I guess the biggest pushback I hear off your call was, why hasn't Microsoft done that more? And so, I mean, what is your view in terms of you talked about scenario and planning and so on, if it is that resetting to a lower bar, why wouldn't you push harder on the cost side? CHRIS LIDDELL: Well, we clearly debated it a lot over the last couple of months, and we could have if we wanted, it's relatively easy, just like it is in your business, to put people out on the street, and change your cost structure overnight. So there's no barrier in a sense of our ability to actually do it. But we took the view that all the people that we currently employ are actually working on things which are going to create value over the next five to ten years, otherwise they shouldn't have been there in the first place. We've taken away some people who worked on some projects which have a lower prioritization, they're still probably creating value, but this is the right thing to do. We talked about downsizing, and we just took the view that even though there will be a reset potentially downwards, investing for the long-term is still the thing that we want to do. Now, that's not -- from a shareholder point of view, we have to still prove that it's going to create economic value over the long-term. Clearly people would rather see us take more cost out in the short-term that's always a balancing act. That's the judgment we made as a senior team, that we would keep resources essentially flat for the foreseeable future. Now, I'll say culturally that's a big change for Microsoft. I've worked in industries where every three or four years you went through a purge. And people just assumed, okay, here we go again, we're going to take 5 percent of the cost out. So I've lived in both environments. Going from an environment that we've had, where people have been used to growing at 10 percent a year, and basically saying those days are over, certainly for the
  12. 12. foreseeable future, you have to now make some serious prioritization decisions about where you're going to spend resources. To most people in the organization, it feels as drastic as some others who are seeing a cut. From an economic point of view, it's clearly not as beneficial. From a cultural point of view, it's almost as powerful. And what I've always said is, the most successful cost initiatives in any company are a combination of strong top down mandating, and a cultural change from below. And if we see the sort of change that I would like to see, where people are no longer seeing their budgets as an opportunity to spend, and see people change their patterns of spending, and their resource allocation in a way that I'd like to see it, then it will be way more successful than just the headline number of us taking another 5,000 people out. SARAH FRIAR: Sure. And it sounds, if I listen to you, though, it's an evolution. This is not a we're done with this, it's never come back to us again. You're watching the top line, you'll be mindful of what the costs are doing. CHRIS LIDDELL: Well, you can never say never on anything. The world will always change. In six months time, if we see a fundamentally different economic environment, then we have to adjust to it. But we aren't sitting there saying, we're ready to go again. We're saying to people, okay, we've done what it is, go and manage your business, go and produce your products, don't sit here waiting for the announcement next month. So we cannot live in a death by a thousand cuts environment. Every strategic plan, every budgeting process, every change in the economy is an opportunity to get smarter, and revisit your decision, but you can't live in a continuous, uncertainty environment. SARAH FRIAR: Sure. I think there's absolutely a balance. Sometimes when I talk to investors about Microsoft, there's a sense of a very dogmatic view of that's done and it's over as opposed to a sense that there's a rebalancing all the time of the strategy. And I think that's what we're hearing from you right now. Shifting below cost to the cash balance, how you think about cash allocation, I think from the strategic update on Tuesday, people were somehow worried that you were sending a message of, we're going to send the dividend to zero, and horde everything up in Redmond. How do you really think about the right cash allocation right now, the right balance sheet, the optimization? CHRIS LIDDELL: Again, if I start with the long-term approach and then characterize it in the current environment, how it might have shifted at the margin, because it's really just shifting at the margin. So from a long-term point of view, we came from a situation where I think we all agreed we had more cash on the balance sheet that we needed to a lower rate. It's still probably not as low as some investors would like, but between Bill, Steve, and myself, we agreed
  13. 13. on a level that we would look to get at, and so we brought it down to that level through buybacks. And the general approach was that we would essentially fund acquisitions if they were the right thing to do. We'd fund capital expenditure. We would increase the dividend essentially broadly in line with earnings per share. And anything that was left over we would use for buybacks. That's still the same basic principle that sits here today. Now, if you look at what's changed in the current environment, acquisitions probably less likely to happen at the moment. Ironically, even though prices have come down I don't think vendor expectations have yet come down to the level where prices have. So who knows, we could obviously -- something could approach us, but it's likely that our acquisition rate will slow, so more cash available. Capital expenditure has been running relatively high, that's likely to come down. We're certainly not going to be building too many more facilities for our employees, and even the data -- SARAH FRIAR: Data center building. CHRIS LIDDELL: Data center expansion is likely to slow. So those look likely to come down. Dividends, a lot of people got concerned about Steve's message the other day. There was no messaging intended whatsoever on dividend. Steve and I had spoken zero minutes on dividends before he talked. We talked a lot about it to investors subsequently. We look at our dividend once a year. Clearly we have to look at what the profitability is at that stage, but that's no prediction at all. We had absolutely no discussion about what we might do on the dividend, certainly no discussion about -- SARAH FRIAR: Microsoft needs to increase the dividend would seem -- you don't pay enough of a dividend -- CHRIS LIDDELL: There was certainly no economic necessity for us to do anything in dividend to hoard cash. We spend about $4 billion a year, depending on what measure you use, we have free cash flow of $10 to $15 billion a year. Dividend cover is not something that I worry about. SARAH FRIAR: Exactly. CHRIS LIDDELL: So it's whatever the right dividend is, as opposed to some economic necessity. And then buybacks, buybacks will continue to be the residual of that. And so we'll still be a net buyer of our shares over the long term. One of the good things is, we generate a lot of free cash flow. Our CAPEX is tiny in comparison. Most of our CAPEX is R&D, effectively, and we expense that. So CAPEX of a couple of billion dollars a year in the context of free cash flow of $10 to 15 is modest. So we will still, in any economic circumstances you can foresee, be a net free cash flow generator, and then hence an overall buyer of our shares.
  14. 14. Now, could we, and I think I signaled this in the call on January, could we go through a quarter or two where we fall back in the buyback, because we're feeling more conservative about the level of cash that we'd like to hold until we get a greater clarity of the economic conditions? Yes, that's possible. But on a medium to long-term basis we'll still be a buyer of our shares, and that will still drive earnings per share growth relative to operating income growth. So nothing has changed, some of the levers have sort of changed a little bit in size, but some of them actually favorably in terms of cash inflow. SARAH FRIAR: With that, let's open it up for a few questions. We have about five minutes. Okay, we have to take one from Rick. QUESTION: Google was teasing him yesterday, could they not afford two microphones. CHRIS LIDDELL: Things are cutting back. QUESTION: Thanks. Chris, on netbooks, the question is on the business model around netbooks, and you've indicated that you'd like to have people trade-up to the higher ASP version of your operating system, and to the degree they'd also like some Office applications, where Google will use Android on phones and on netbooks, and probably give you free access to their applications in the cloud, what kind of business model issues do you see if they're maybe getting subsidized through advertising, and getting paid that way, and you're charging more. Isn't that a more challenging business model for you on low price platforms? Can you kind of talk to that issue? CHRIS LIDDELL: Well, we've been competing against free for a long time, of course. So, again, it comes back to the experience, what's the fundamental experience you get out of Windows. Now, Windows is clearly a familiar environment that's useful, the whole Office environment and everything that you get with Windows, and all the applications that sit on top of it are incredibly powerful to the overall experience. So it will be a competitive issue, but Android on a -- let's say an ARM processor versus the basic Windows experience on an Intel processor, relatively speaking, in terms of the dollars, and I'll come back to it, if it was $100-200 maybe there isn't a business case for that. If it's a relatively modest amount of money we think it's still a very good business case So clearly will it put pressure on? Absolutely, just like every other competitive threat that we've faced in the last 10 years. So there's an inevitable challenge, but it's not one from our point of view that's certainly life threatening. QUESTION: With Windows Mobile 7 handsets -- CHRIS LIDDELL: You might not want to hog all the questions.
  15. 15. QUESTION: Okay. I guess the question was, you have two different operating systems on netbooks and -- CHRIS LIDDELL: Somebody has to grab the phone off you to do it. Sorry, what was that? Sorry, Rick, what was it? QUESTION: The different operating systems on the handsets versus the netbooks, with Windows Mobile 7 coming, is there going to be a convergence in the operating systems for those two different platforms? CHRIS LIDDELL: Not necessarily in the timeframe we're talking about, but convergence of the experience is something that we are thinking about very hard. QUESTION: Just a question on capital structure, in light of the $4 billion debt shelf registration Microsoft has outstanding, could you just talk about what level of absolute debt you think is appropriate to maximize tax efficient shareholder returns, in the context of your AAA credit rating, and maybe how you see that gross debt balance, or some ratio gearing evolving over the medium term, 2009-2010? CHRIS LIDDELL: Yes, we put a shelf in place actually for practical reasons rather than capital structure reasons, just to be clear. So a lot of our cash is generated off shore, and a lot of the current cash balance that we have is outside the U.S., whereas a lot of the requirements we have by capital expenditure, dividend obviously, needs to be paid out in U.S. funds, and buyback does, as well. So you could see a situation where we borrow domestically in order to fund some of our activities, and build the balance offshore, as well, so to have a matching between those two. So don't take the shelf registration as an indication that we're looking to fundamentally change the capital structure, it was simply a practical matter, and obviously the rates are relatively attractive for us at the moment. So it's something that we could do what I've described as modest amounts for Microsoft, $1, $2, $3 billion at some stage over the next six months or so. You won't see us -- I wouldn't want to promise that you'll see a fundamental change in our capital structure, with us significantly leveraging the company in the foreseeable future. QUESTION: You have $2 billion in CP outstanding right now, I mean, should we think about the potential debt rising in order to repatriate some funds back to the U.S., as being over and above that $2 billion, just to get some context of total size? CHRIS LIDDELL: Yes, the $2 billion in Microsoft's context is obviously very small. And the rates -- I mean, we've been borrowing at 20-25 basis points, absolute. So it's just incredibly attractive finances from our point of view, and the AAA rating - we're a little precious to contain that. So, yes, it would be over and above that. SARAH FRIAR: I think there's one or two back here. We'll run over slightly, just to allow two questions. If I can take this mike first, then we'll pass the mike to you, sir.
  16. 16. QUESTION: Chris, there's been a lot of discussion recently about browser market share. What is your thought about the threat of the relevance of the operating system longer-term to the browser, and what is your response, or what are your thoughts about your browser market share, and how important that is to you? CHRIS LIDDELL: Well, clearly it's important. It's not critical, it's important, and we're as disappointed as anyone to see, obviously, the browser share decline. But the operating system is much more than just the browser-related experience. So our challenge, as with all of our challenges, is to get a product experience that is successful. And we need to be better from a browser point of view to stop that market erosion, by having a better experience. Now I think IE 8 is fundamentally better than IE 7 or IE 6, but we need to see continued improvements in the browser, and I would say, a little like the comment I made to Sarah before, we haven't necessarily put the resource in that area that I think we should have over the last five years. That quite clearly is changing, in terms of the prioritization of resources. So it's not the most critical area that we face, but it's a very important one. SARAH FRIAR: Okay. We'll take one more very briefly. QUESTION: A quick question about the monetization model for making money in mobile, and thinking about the recent Verizon deal, where Windows Mobile was effectively free, and Microsoft guaranteed payments to Verizon over some number of years so does this mean that essentially Windows Mobile is closed-source, but royalty- free, and then how do you make money in mobile? CHRIS LIDDELL: Yes, you're netting two different things, and so I'll break them apart. We will and still charge for our operating system. Relative to, say, a PC, the amount is obviously clearly going to be significantly lower. So our challenge there is to get scale. So we sell 20 million units at the moment, we need to get to a business model where we can sell more than 100 million units, rather than 20 million units, to get the scale, and for the revenue to be significant, because we are never going to be able to charge a revenue per mobile handset that's anything like, say, a PC. On the Verizon deal, the subsidization that you're talking about was on the search side. So if you like, there's a charge for the underlying operating system, then there's the revenue that we're able to achieve through mobile search. Mobile search is pretty embryonic at the moment, and relatively tough. We made a decision that it was important to have a presence in the mobile search area. We were willing to do a deal, which is pretty tough economics in order to do that. Obviously that offset what we were getting from the basic operating system, but that's a different fundamental economic challenge. Can we, and others for that matter, make a good revenue model of mobile search, and if we can how do we bootstrap that, and how much of the economics are we willing to give to the mobile operator in doing it?
  17. 17. SARAH FRIAR: Okay. We unfortunately have to break there. Chris, thanks so much for making the time. It was a pleasure. (Applause.) CHRIS LIDDELL: Thank you. END