MICROSOFT CORPORATION Note About Forward-Looking Statements
This report includes estimates, projections, statements relating to our business
plans, objectives, and expected operating results that are "forward-looking
statements" within the meaning of the Private Securities Litigation Reform Act
of 1995, Section 27A of the Securities Act of 1933, and Section 21E of the
Securities Exchange Act of 1934. Forward-looking statements may appear
throughout this report, including the following sections: "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
"Risk Factors" (Part II, Item 1A of this Form 10-Q). These forward-looking
statements generally are identified by the words "believe," "project," "expect,"
"anticipate," "estimate," "intend," "strategy," "future," "opportunity," "plan,"
"may," "should," "will," "would," "will be," "will continue," "will likely
result," and similar expressions. Forward-looking statements are based on
current expectations and assumptions that are subject to risks and uncertainties
that may cause actual results to differ materially. We describe risks and
uncertainties that could cause actual results and events to differ materially in
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," "Quantitative and Qualitative Disclosures about Market Risk" (Part
I, Item 3 of this Form 10-Q), and "Risk Factors". We undertake no obligation to
update or revise publicly any forward-looking statements, whether because of new
information, future events, or otherwise.
The following Management's Discussion and Analysis of Financial Condition and
Results of Operations ("MD&A") is intended to help the reader understand the
results of operations and financial condition of Microsoft Corporation . MD&A is
provided as a supplement to, and should be read in conjunction with, our Annual
Report on Form 10-K for the year ended June 30, 2020 , and our financial
statements and the accompanying Notes to Financial Statements (Part I, Item 1 of
this Form 10-Q).
OVERVIEW
Microsoft is a technology company whose mission is to empower every person and
every organization on the planet to achieve more. We strive to create local
opportunity, growth, and impact in every country around the world. Our platforms
and tools help drive small business productivity, large business
competitiveness, and public-sector efficiency. They also support new startups,
improve educational and health outcomes, and empower human ingenuity.
We generate revenue by offering a wide range of cloud-based and other services
to people and businesses; licensing and supporting an array of software
products; designing, manufacturing, and selling devices; and delivering relevant
online advertising to a global audience. Our most significant expenses are
related to compensating employees; designing, manufacturing, marketing, and
selling our products and services; datacenter costs in support of our
cloud-based services; and income taxes.
As the world continues to respond to the coronavirus ("COVID-19"), we are
working to do our part by ensuring the safety of our employees, striving to
protect the health and well-being of the communities in which we operate, and
providing technology and resources to our customers to help them do their best
work while remote.
Highlights from the second quarter of fiscal year 2021 compared with the second quarter of fiscal year 2020 included:
• Commercial cloud revenue increased 34% to
• Office Commercial products and cloud services revenue increased 11%,
driven by Office 365 Commercial growth of 21%.
• Office Consumer products and cloud services revenue increased 7%, and
Microsoft 365 Consumer subscribers increased to 47.5 million. • LinkedIn revenue increased 23%.
• Dynamics products and cloud services revenue increased 21%, driven by
Dynamics 365 growth of 39%.
• Server products and cloud services revenue increased 26%, driven by Azure
growth of 50%.
• Windows original equipment manufacturer licensing ("Windows OEM") revenue
increased 1%.
• Windows Commercial products and cloud services revenue increased 10%.
• Xbox content and services revenue increased 40%.
• Surface revenue increased 3%.
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• Search advertising revenue, excluding traffic acquisition costs, increased
2%.
Industry Trends
Our industry is dynamic and highly competitive, with frequent changes in both
technologies and business models. Each industry shift is an opportunity to
conceive new products, new technologies, or new ideas that can further transform
the industry and our business. At Microsoft , we push the boundaries of what is
possible through a broad range of research and development activities that seek
to identify and address the changing demands of customers and users, industry
trends, and competitive forces.
Economic Conditions, Challenges, and Risks
The markets for software, devices, and cloud-based services are dynamic and highly competitive. Our competitors are developing new software and devices, while also deploying competing cloud-based services for consumers and businesses. The devices and form factors customers prefer evolve rapidly, and influence how users access services in the cloud, and in some cases, the user's choice of which suite of cloud-based services to use. We must continue to evolve and adapt over an extended time in pace with this changing environment. The investments we are making in infrastructure and devices will continue to increase our operating costs and may decrease our operating margins. Our success is highly dependent on our ability to attract and retain qualified employees. We hire a mix of university and industry talent worldwide. We compete for talented individuals globally by offering an exceptional working environment, broad customer reach, scale in resources, the ability to grow one's career across many different products and businesses, and competitive compensation and benefits. Aggregate demand for our software, services, and devices is correlated to global macroeconomic and geopolitical factors, which remain dynamic. Our international operations provide a significant portion of our total revenue and expenses. Many of these revenue and expenses are denominated in currencies other than theU.S. dollar. As a result, changes in foreign exchange rates may significantly affect revenue and expenses. Weakening of theU.S. dollar relative to certain foreign currencies increased reported revenue but did not have a material impact on reported expenses from our international operations for the three months endedDecember 31, 2020 , and did not have a material impact on reported revenue or expenses from our international operations for the six months endedDecember 31, 2020 .
Refer to Risk Factors (Part II, Item 1A of this Form 10-Q) for a discussion of these factors and other risks.
COVID-19
In fiscal year 2021, the COVID-19 pandemic continued to impact our business operations and financial results. Cloud usage and demand benefited as customers accelerate their digital transformation priorities. Our consumer businesses also benefited from the remote environment, with continued demand for PCs and productivity tools, as well as strong engagement across our Gaming platform. We saw improvement in customer advertising spend, but continued to experience weakness in transactional licensing and savings in operating expenses related to COVID-19. The COVID-19 pandemic may continue to impact our business operations and financial operating results, and there is uncertainty in the nature and degree of its continued effects over time. Refer to Risk Factors (Part II, Item 1A of this Form 10-Q) for further discussion.
Seasonality
Our revenue fluctuates quarterly and is generally higher in the second and fourth quarters of our fiscal year. Second quarter revenue is driven by corporate year-end spending trends in our major markets and holiday season spending by consumers, and fourth quarter revenue is driven by the volume of multi-year on-premises contracts executed during the period.
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Change in Accounting Estimate
InJuly 2020 , we completed an assessment of the useful lives of our server and network equipment and determined we should increase the estimated useful life of server equipment from three years to four years and increase the estimated useful life of network equipment from two years to four years. This change in accounting estimate was effective beginning fiscal year 2021. Based on the carrying amount of server and network equipment included in property and equipment, net as ofJune 30, 2020 , the effect of this change in estimate for the three months endedDecember 31, 2020 , was an increase in operating income of$787 million and net income of$649 million , or$0.09 per both basic and diluted share. The effect of this change for the six months endedDecember 31, 2020 , was an increase in operating income of$1.7 billion and net income of$1.4 billion , or$0.19 per both basic and diluted share. It is estimated this change will increase our fiscal year 2021 annual operating income by$2.7 billion .
Reportable Segments
We report our financial performance based on the following segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing. The segment amounts included in MD&A are presented on a basis consistent with our internal management reporting. All differences between our internal management reporting basis and accounting principles generally accepted inthe United States of America ("GAAP"), along with certain corporate-level and other activity, are included in Corporate and Other.
Additional information on our reportable segments is contained in Note 17 - Segment Information and Geographic Data of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q).
Metrics
We use metrics in assessing the performance of our business and to make informed decisions regarding the allocation of resources. We disclose metrics to enable investors to evaluate progress against our ambitions, provide transparency into performance trends, and reflect the continued evolution of our products and services. Our commercial and other business metrics are fundamentally connected based on how customers use our products and services. The metrics are disclosed in the MD&A or the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q). Financial metrics are calculated based on GAAP results and growth comparisons relate to the corresponding period of last fiscal year.
Commercial
Our commercial business primarily consists of Server products and cloud services, Office Commercial, Windows Commercial, the commercial portion of LinkedIn, Enterprise Services, and Dynamics. Our commercial metrics allow management and investors to assess the overall health of our commercial business and include leading indicators of future performance.
Commercial remaining performance obligation Commercial portion of revenue allocated to
remaining performance obligations, which
includes unearned revenue and amounts that will
be invoiced and recognized as revenue in future
periods
Commercial cloud revenue Revenue from our commercial cloud business,
which includes Office 365 Commercial, Azure, the
commercial portion of LinkedIn, Dynamics 365,
and other commercial cloud properties
Commercial cloud gross margin percentage Gross margin percentage for our commercial cloud
business
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Productivity and Business Processes and Intelligent Cloud
Metrics related to our Productivity and Business Processes and Intelligent Cloud segments assess the health of our core businesses within these segments. The metrics reflect our cloud and on-premises product strategies and trends.
Office Commercial products and cloud services revenue growth Revenue from Office Commercial products and
cloud services, including Office 365
subscriptions, the Office 365 portion of
Microsoft
365 Commercial subscriptions, and
Office licensed on-premises, comprising Office,
Exchange,
SharePoint,
365 Security
and Compliance, and
Business, and related Client Access Licenses
("CALs")
Office Consumer products and cloud services revenue growth Revenue from Office Consumer products and cloud
services,
including
subscriptions and Office licensed on-premises
Office 365 Commercial seat growth The number
of Office 365 Commercial seats at end
of period where seats are paid users covered by
an Office 365 Commercial subscription
Microsoft 365 Consumer subscribers The number
of
Office 365 Consumer) subscribers at end of
period
Dynamics products and cloud services revenue growth Revenue from Dynamics products and cloud
services, including Dynamics 365, comprising a
set of intelligent, cloud-based applications
across ERP, CRM, and Customer Data Platform;
low-code application platform and automation
solutions; and on-premises ERP and CRM
applications
LinkedIn revenue growth Revenue from LinkedIn, including Talent
Solutions, Learning Solutions, Marketing
Solutions, Sales Solutions, and Premium
Subscriptions
Server products and cloud services revenue growth Revenue from Server products and cloud services,
including Azure; SQL Server, Windows Server,
Visual Studio, System Center, and related CALs;
and GitHub
More Personal Computing
Metrics related to our More Personal Computing segment assess the performance of
key lines of business within this segment. These metrics provide strategic
product insights which allow us to assess the performance across our commercial
and consumer businesses. As we have diversity of target audiences and sales
motions within the Windows business, we monitor metrics that are reflective of
those varying motions.
Windows OEM Pro revenue growth Revenue from sales of Windows Pro licenses sold
through the OEM channel, which primarily
addresses demand in the commercial market
Windows OEM non-Pro revenue growth Revenue
from sales of Windows non-Pro licenses
sold through the OEM channel, which primarily
addresses demand in the consumer market
Windows Commercial products and cloud services revenue growth Revenue from Windows Commercial products and
cloud services, comprising volume licensing of
the Windows operating system, Windows cloud
services, and other Windows commercial offerings
Surface revenue Revenue
from Surface devices and accessories
Xbox content and services revenue growth Revenue
from Xbox content and services,
comprising Xbox Live (transactions, Xbox Game
Pass and other subscriptions, cloud services,
and advertising), video games, and third-party
video game royalties
Search advertising revenue, excluding TAC, growth Revenue
from search advertising excluding
traffic acquisition costs ("TAC") paid to Bing
Ads network publishers
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SUMMARY RESULTS OF OPERATIONS
(In millions, except percentages and per share Three Months Ended Percentage Six Months Ended Percentage
amounts) December 31, Change December 31, Change
2020 2019 2020 2019
Revenue $ 43,076 $ 36,906 17% $ 80,230 $ 69,961 15%
Gross margin 28,882 24,548 18% 55,034 47,197 17%
Operating income 17,897 13,891 29% 33,773 26,577 27%
Net income 15,463 11,649 33% 29,356 22,327 31%
Diluted earnings per share 2.03 1.51 34% 3.85 2.90 33%
Three Months Ended
Revenue increased$6.2 billion or 17%, driven by growth across each of our segments. Intelligent Cloud revenue increased, driven by server products and cloud services. More Personal Computing revenue increased, driven by Gaming. Productivity and Business Processes revenue increased, driven by Office Commercial and LinkedIn. Cost of revenue increased$1.8 billion or 15%, driven by growth in Gaming and commercial cloud, offset in part by a reduction in depreciation expense due to the change in estimated useful lives of our server and network equipment. Gross margin increased$4.3 billion or 18%, driven by growth across each of our segments and the change in estimated useful lives of our server and network equipment. Gross margin percentage increased slightly, driven by the change in estimated useful lives of our server and network equipment. Commercial cloud gross margin percentage increased 4 points to 71%, driven by the change in estimated useful lives of our server and network equipment. Excluding this impact, commercial cloud gross margin percentage was relatively unchanged, driven by gross margin percentage improvement in Azure, offset in part by sales mix shift to Azure. Operating expenses increased$328 million or 3%, driven by investments in cloud engineering and commercial sales, offset in part by savings related to COVID-19 across each of our segments.
Key changes in operating expenses were:
• Research and development expenses increased
investments in cloud engineering.
• Sales and marketing expenses were relatively unchanged, driven by
investments in commercial sales, offset in part by reductions in
advertising.
• General and administrative expenses increased $18 million or 2%.
Operating income increased $4.0 billion or 29%, driven by growth across each of
our segments and the change in estimated useful lives of our server and network
equipment.
Revenue, gross margin, and operating income included a favorable foreign currency impact of 2%, 2%, and 3%, respectively.
Six Months Ended
Revenue increased$10.3 billion or 15%, driven by growth across each of our segments. Intelligent Cloud revenue increased, driven by server products and cloud services. Productivity and Business Processes revenue increased, driven by Office Commercial and LinkedIn. More Personal Computing revenue increased, driven by Gaming. Cost of revenue increased$2.4 billion or 11%, driven by growth in commercial cloud and Gaming, offset in part by the change in estimated useful lives of our server and network equipment. Gross margin increased$7.8 billion or 17%, driven by growth across each of our segments and the change in estimated useful lives of our server and network equipment. Gross margin percentage increased, driven by the change in estimated useful lives of our server and network equipment. Commercial cloud gross margin percentage increased 4 points to 71%, driven by the change in estimated useful lives of our server and network equipment. Excluding this impact, commercial cloud gross margin percentage increased slightly, driven by gross margin percentage improvement in Azure, offset in part by sales mix shift to Azure. 35 --------------------------------------------------------------------------------
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Operating expenses increased $641 million or 3%, driven by investments in cloud
engineering and commercial sales, offset in part by savings related to COVID-19
across each of our segments.
Key changes in operating expenses were:
• Research and development expenses increased
investments in cloud engineering.
• Sales and marketing expenses decreased $92 million or 1%, driven byreductions in advertising, offset in part by investments in commercial
sales.
• General and administrative expenses increased
an increase in business taxes.
Operating income increased$7.2 billion or 27%, driven by growth across each of our segments and the change in estimated useful lives of our server and network equipment. Gross margin and operating income both included a favorable foreign currency impact of 2%. SEGMENT RESULTS OF OPERATIONS (In millions, except Three Months Ended Percentage Six Months Ended Percentage percentages) December 31, Change December 31, Change 2020 2019 2020 2019 Revenue Productivity and Business $ Processes$ 13,353 $ 11,826 13%$ 25,672 22,903 12% Intelligent Cloud 14,601 11,869 23% 27,587 22,714 21% More Personal Computing 15,122 13,211 14% 26,971 24,344 11% Total$ 43,076 $ 36,906 17%$ 80,230 $ 69,961 15% Operating Income Productivity and Business $ Processes$ 6,181 $ 5,182 19%$ 11,887 9,964 19% Intelligent Cloud 6,492 4,531 43% 11,914 8,420 41% More Personal Computing 5,224 4,178 25% 9,972 8,193 22% Total$ 17,897 $ 13,891 29%$ 33,773 $ 26,577 27% Reportable Segments
Three Months Ended
Productivity and Business Processes
Revenue increased
• Office Commercial products and cloud services revenue increased
million or 11%, on a strong prior year comparable. Office 365 Commercial
revenue grew 21%, due to seat growth of 15% and higher revenue per user.
Office Commercial products revenue declined 26%, driven by continued
customer shift to cloud offerings from multi-year on-premises agreements
and continued transactional weakness, on a strong prior year comparable
that benefited from transactional strength, primarily in
• Office Consumer products and cloud services revenue increased
or 7%, driven by
prior year comparable that benefited from transactional strength in
• LinkedIn revenue increased
demand in our Marketing Solutions business.
• Dynamics products and cloud services revenue increased 21%, driven by
Dynamics 365 growth of 39%.
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Operating income increased
• Gross margin increased
and Office Commercial, and the change in estimated useful lives of our
server and network equipment. Gross margin percentage was relatively
unchanged with the change in estimated useful lives of our server and
network equipment. Excluding this impact, gross margin percentage
decreased, driven by increased usage of Office 365 Commercial and a sales
mix shift to cloud offerings.
• Operating expenses increased
commercial sales, Teams marketing, and cloud engineering.
Revenue, gross margin, and operating income each included a favorable foreign currency impact of 2%.
Intelligent Cloud
Revenue increased
• Server products and cloud services revenue increased
driven by Azure. Azure revenue grew 50%, due to growth in our
consumption-based services. Server products revenue increased 4%, driven
by hybrid and premium solutions, offset in part by continued transactional
weakness, on a strong prior year comparable that benefited from demand
related to Windows Server 2008 end of support.
• Enterprise Services revenue increased
in
Operating income increased
• Gross margin increased
products and cloud services and the change in estimated useful lives of
our server and network equipment. Gross margin percentage increased with
the change in estimated useful lives of our server and network equipment.
Excluding this impact, gross margin percentage increased slightly, driven
by gross margin percentage improvement in Azure, offset in part by sales
mix shift to Azure.
• Operating expenses increased
Azure.
Gross margin and operating income both included a favorable foreign currency impact of 2%.
More Personal Computing
Revenue increased
• Windows revenue increased
Commercial. Windows Commercial products and cloud services revenue
increased 10%, primarily driven by demand for
revenue increased 1%, driven by consumer PC demand, on a strong prior year
OEM Pro comparable that benefited from Windows 7 end of support. Windows
OEM Pro revenue decreased 9% and Windows OEM non-Pro revenue grew 24%.
• Gaming revenue increased $1.7 billion or 51%, driven by growth in Xboxcontent and services and Xbox hardware. Xbox content and services revenue
increased
revenue increased 86%, driven by higher price of consoles sold due to the
Xbox Series X|S launches.
• Surface revenue increased $69 million or 3%.
• Search advertising revenue increased slightly. Search advertising revenue,
excluding traffic acquisition costs, increased 2%, primarily driven by
higher search volume, offset in part by lower revenue per search.
Operating income increased
• Gross margin increased
Windows. Gross margin percentage decreased, driven by sales mix shift to
Gaming.
• Operating expenses decreased
marketing and retail store expenses.
Gross margin and operating income included a favorable foreign currency impact of 2% and 3%, respectively.
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Six Months Ended
Productivity and Business Processes
Revenue increased
• Office Commercial products and cloud services revenue increased
billion or 10%, on a strong prior year comparable. Office 365 Commercial
revenue grew 21%, due to seat growth and higher revenue per user. Office
Commercial products revenue declined 28%, driven by continued customer
shift to cloud offerings from multi-year on-premises agreements and
continued transactional weakness, on a strong prior year comparable that
benefited from transactional strength in Japan .
• Office Consumer products and cloud services revenue increased
or 10%, driven by Microsoft 365 Consumer subscription revenue, on a strong
prior year comparable that benefited from transactional strength in Japan .
• LinkedIn revenue increased
demand in our Marketing Solutions business.
• Dynamics products and cloud services revenue increased 20%, driven by
Dynamics 365 growth of 38%.
Operating income increased
• Gross margin increased
currency impact of 2%, driven by growth in LinkedIn and Office Commercial,
and the change in estimated useful lives of our server and network
equipment. Gross margin percentage increased slightly with the change in
estimated useful lives of our server and network equipment. Excluding this
impact, gross margin percentage decreased, driven by increased usage of
Office 365 Commercial and a sales mix shift to cloud offerings.
• Operating expenses increased
commercial sales, Teams marketing, and cloud engineering.
Intelligent Cloud
Revenue increased
• Server products and cloud services revenue increased
driven by Azure. Azure revenue grew 49%, due to growth in our
consumption-based services. Server products revenue increased 1%, driven
by hybrid and premium solutions, offset in part by continued transactional
weakness, on a strong prior year comparable that benefited from demand
related to SQL Server 2008 and Windows Server 2008 end of support.
• Enterprise Services revenue increased
in
Operating income increased
• Gross margin increased
products and cloud services and the change in estimated useful lives of
our server and network equipment. Gross margin percentage increased with
the change in estimated useful lives of our server and network equipment.
Excluding this impact, gross margin percentage was relatively unchanged,
driven by gross margin percentage improvement in Azure, offset in part by
sales mix shift to Azure.
• Operating expenses increased
Azure.
More Personal Computing
Revenue increased
• Windows revenue increased
Windows Commercial, offset in part by a decrease in Windows OEM. Windows
Commercial products and cloud services revenue increased 11%, driven by
demand for
prior year OEM Pro comparable that benefited from Windows 7 end of
support, offset in part by consumer PC demand. Windows OEM Pro revenue
decreased 15% and Windows OEM non-Pro revenue grew 27%.
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• Gaming revenue increased $2.3 billion or 38%, driven by growth in Xboxcontent and services and Xbox hardware. Xbox content and services revenue
increased
revenue increased 51%, driven by higher price of consoles sold due to the
Xbox Series X|S launches.
• Surface revenue increased
• Search advertising revenue decreased $181 million or 4%. Search
advertising revenue, excluding traffic acquisition costs, decreased 4%,
driven by lower revenue per search, offset in part by higher search
volume.
Operating income increased
• Gross margin increased
Surface, and Windows. Gross margin percentage decreased slightly, driven
by sales mix shift to lower margin businesses.
• Operating expenses decreased
marketing and retail store expenses.
OPERATING EXPENSES
Research and Development
Three Months Ended Percentage Six Months Ended Percentage
(In millions, except percentages) December 31, Change December 31, Change
2020 2019 2020 2019
Research and development $ 4,899 $ 4,603 6% $ 9,825 $ 9,168 7%
As a percent of revenue 11% 12% (1)ppt 12% 13% (1)ppt
Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code and services content.
Three Months Ended
Research and development expenses increased
Six Months Ended
Research and development expenses increased
Sales and Marketing
Three Months Ended Percentage Six Months Ended Percentage
(In millions, except percentages) December 31, Change December 31, Change
2020 2019 2020 2019
Sales and marketing $ 4,947 $ 4,933 0% $ 9,178 $ 9,270 (1)%As a percent of revenue 11% 13% (2)ppt 11% 13% (2)ppt Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, trade shows, seminars, and other programs.
Three Months Ended
Sales and marketing expenses were relatively unchanged, driven by investments in commercial sales, offset in part by reductions in advertising.
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Six Months Ended
Sales and marketing expenses decreased
General and Administrative
Three Months Ended Percentage Six Months Ended Percentage
(In millions, except percentages) December 31, Change December 31, Change
2020 2019 2020 2019
General and administrative $ 1,139 $ 1,121 2% $ 2,258 $ 2,182 3%
As a percent of revenue 3% 3% 0ppt 3% 3% 0ppt
General and administrative expenses include payroll, employee benefits,
stock-based compensation expense, severance expense, and other headcount-related
expenses associated with finance, legal, facilities, certain human resources and
other administrative personnel, certain taxes, and legal and other
administrative fees.
Three Months Ended
General and administrative expenses increased
Six Months Ended
General and administrative expenses increased
OTHER INCOME (EXPENSE), NETThe components of other income (expense), net were as follows:
Three Months Ended Six Months Ended
(In millions) December 31, December 31,
2020 2019 2020 2019
Interest and dividends income $ 545 $ 688 $ 1,115 $ 1,412
Interest expense (571 ) (654 ) (1,160 ) (1,291 )
Net recognized gains on investments 359 162 484 105
Net gains (losses) on derivatives (5 ) 41 (2 ) 87
Net gains (losses) on foreign currency
remeasurements 42 (24 ) 181 (82 )
Other, net 70 (19 ) 70 (37 )
Total $ 440 $ 194 $ 688 $ 194 We use derivative instruments to: manage risks related to foreign currencies, equity prices, interest rates, and credit; enhance investment returns; and facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are not designated as hedging instruments are primarily recognized in other income (expense), net.
Three Months Ended
Interest and dividends income decreased due to lower yields on fixed-income
securities. Interest expense decreased due to a decrease in outstanding
long-term debt due to debt maturities and higher capitalization of interest
expense, offset in part by higher finance lease expense. Net recognized gains on
investments increased due to higher gains on equity securities. Net losses on
derivatives increased due to losses on foreign exchange derivatives compared to
gains in the prior period.
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Six Months Ended
Interest and dividends income decreased due to lower yields on fixed-income
securities. Interest expense decreased due to a decrease in outstanding
long-term debt due to debt maturities and higher capitalization of interest
expense, offset in part by higher finance lease expense. Net recognized gains on
investments increased due to higher gains on equity securities. Net losses on
derivatives increased due to losses on foreign exchange derivatives compared to
gains in the prior period.
INCOME TAXESEffective Tax Rate
Our effective tax rate was 16% and 17% for the three months endedDecember 31, 2020 and 2019, respectively, and 15% and 17% for the six months endedDecember 31, 2020 and 2019, respectively. The decrease in our effective tax rate for the three and six months endedDecember 31, 2020 compared to the prior year was primarily due to tax benefits from final Tax Cuts and Jobs Act ("TCJA") regulations and an increase in tax benefits relating to stock-based compensation. Our effective tax rate was lower than theU.S. federal statutory rate for the three months and six months endedDecember 31, 2020 , primarily due to earnings taxed at lower rates in foreign jurisdictions resulting from producing and distributing our products and services through our foreign regional operations centers inIreland andPuerto Rico , and tax benefits relating to stock-based compensation. Uncertain Tax Positions We settled a portion of the Internal Revenue Service ("IRS") audit for tax years 2004 to 2006 in fiscal year 2011. InFebruary 2012 , theIRS withdrew its 2011 Revenue Agents Report related to unresolved issues for tax years 2004 to 2006 and reopened the audit phase of the examination. We also settled a portion of theIRS audit for tax years 2007 to 2009 in fiscal year 2016, and a portion of theIRS audit for tax years 2010 to 2013 in fiscal year 2018. In the second quarter of fiscal year 2021, we settled an additional portion of theIRS audits for tax years 2004 to 2013 and made a payment of$1.7 billion , including tax and interest. We remain under audit for tax years 2004 to 2017. As ofDecember 31, 2020 , the primary unresolved issues for theIRS audits relate to transfer pricing, which could have a material impact in our consolidated financial statements when the matters are resolved. We believe our allowances for income tax contingencies are adequate. We have not received a proposed assessment for the unresolved key transfer pricing issues and do not expect a final resolution of these issues in the next 12 months. Based on the information currently available, we do not anticipate a significant increase or decrease to our tax contingencies for these issues within the next 12 months. We are subject to income tax in many jurisdictions outside theU.S. Our operations in certain jurisdictions remain subject to examination for tax years 1996 to 2020, some of which are currently under audit by local tax authorities. The resolution of each of these audits is not expected to be material to our consolidated financial statements. FINANCIAL CONDITION
Cash, Cash Equivalents, and Investments
Cash, cash equivalents, and short-term investments totaled$132.0 billion and$136.5 billion as ofDecember 31, 2020 andJune 30, 2020 . Equity investments were$3.8 billion and$3.0 billion as ofDecember 31, 2020 andJune 30, 2020 , respectively. Our short-term investments are primarily intended to facilitate liquidity and capital preservation. They consist predominantly of highly liquid investment-grade fixed-income securities, diversified among industries and individual issuers. The investments are predominantlyU.S. dollar-denominated securities, but also include foreign currency-denominated securities to diversify risk. Our fixed-income investments are exposed to interest rate risk and credit risk. The credit risk and average maturity of our fixed-income portfolio are managed to achieve economic returns that correlate to certain fixed-income indices. The settlement risk related to these investments is insignificant given that the short-term investments held are primarily highly liquid investment-grade fixed-income securities. 41 --------------------------------------------------------------------------------
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Valuation
In general, and where applicable, we use quoted prices in active markets for
identical assets or liabilities to determine the fair value of our financial
instruments. This pricing methodology applies to our Level 1 investments, such
as U.S. government securities, common and preferred stock, and mutual funds. If
quoted prices in active markets for identical assets or liabilities are not
available to determine fair value, then we use quoted prices for similar assets
and liabilities or inputs other than the quoted prices that are observable
either directly or indirectly. This pricing methodology applies to our Level 2
investments, such as commercial paper, certificates of deposit, U.S. agency
securities, foreign government bonds, mortgage- and asset-backed securities,
corporate notes and bonds, and municipal securities. Level 3 investments are
valued using internally-developed models with unobservable inputs. Assets and
liabilities measured at fair value on a recurring basis using unobservable
inputs are an immaterial portion of our portfolio.
A majority of our investments are priced by pricing vendors and are generally
Level 1 or Level 2 investments as these vendors either provide a quoted market
price in an active market or use observable inputs for their pricing without
applying significant adjustments. Broker pricing is used mainly when a quoted
price is not available, the investment is not priced by our pricing vendors, or
when a broker price is more reflective of fair values in the market in which the
investment trades. Our broker-priced investments are generally classified as
Level 2 investments because the broker prices these investments based on similar
assets without applying significant adjustments. In addition, all our
broker-priced investments have a sufficient level of trading volume to
demonstrate that the fair values used are appropriate for these investments. Our
fair value processes include controls that are designed to ensure appropriate
fair values are recorded. These controls include model validation, review of key
model inputs, analysis of period-over-period fluctuations, and independent
recalculation of prices where appropriate.
Cash Flows
Cash from operations increased$7.4 billion to$31.9 billion for the six months endedDecember 31, 2020 , mainly due to an increase in cash received from customers, offset in part by an increase in cash paid to suppliers and employees. Cash used in financing increased$4.8 billion to$23.9 billion for the six months endedDecember 31, 2020 , mainly due to a$3.2 billion increase in common stock repurchases, a$732 million increase in repayments of debt, and a$690 million increase in dividends paid. Cash used in investing decreased$772 million to$7.0 billion for the six months endedDecember 31, 2020 , mainly due to a$5.0 billion increase in cash from net investment purchases, sales, and maturities, offset in part by a$2.2 billion increase in additions to property and equipment and$1.8 billion in other investing to facilitate the purchase of components. Debt We issue debt to take advantage of favorable pricing and liquidity in the debt markets, reflecting our credit rating and the low interest rate environment. The proceeds of these issuances were or will be used for general corporate purposes, which may include, among other things, funding for working capital, capital expenditures, repurchases of capital stock, acquisitions, and repayment of existing debt. InJune 2020 , we exchanged a portion of our existing debt at premium for cash and new debt with longer maturities to take advantage of favorable financing rates in the debt markets, reflecting our credit rating and the low interest rate environment. Refer to Note 10 - Debt of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion.
Unearned Revenue
Unearned revenue comprises mainly unearned revenue related to volume licensing
programs, which may include Software Assurance ("SA") and cloud services.
Unearned revenue is generally invoiced annually at the beginning of each
contract period for multi-year agreements and recognized ratably over the
coverage period. Unearned revenue also includes payments for other offerings for
which we have been paid in advance and earn the revenue when we transfer control
of the product or service.
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The following table outlines the expected future recognition of unearned revenue
as of
(In millions) Three Months EndingMarch 31, 2021 $ 14,418 June 30, 2021 9,342 September 30, 2021 4,260December 31, 2021 2,382 Thereafter 2,985 Total$ 33,387
If our customers choose to license cloud-based versions of our products and services rather than licensing transaction-based products and services, the associated revenue will shift from being recognized at the time of the transaction to being recognized over the subscription period or upon consumption, as applicable.
Share Repurchases
For the six months endedDecember 31, 2020 and 2019, we repurchased 52 million shares and 61 million shares of our common stock for$11.0 billion and$8.6 billion , respectively, through our share repurchase programs. All repurchases were made using cash resources. Refer to Note 15 - Stockholders' Equity of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion. Dividends
Refer to Note 15 - Stockholders' Equity of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion.
Off-Balance Sheet Arrangements
We provide indemnifications of varying scope and size to certain customers against claims of intellectual property infringement made by third parties arising from the use of our products and certain other matters. Additionally, we have agreed to cover damages resulting from breaches of certain security and privacy commitments in our cloud business. In evaluating estimated losses on these obligations, we consider factors such as the degree of probability of an unfavorable outcome and our ability to make a reasonable estimate of the amount of loss. These obligations did not have a material impact in our consolidated financial statements during the periods presented.
Other Planned Uses of Capital
OnSeptember 19, 2020 , we entered into a definitive agreement to acquireZeniMax Media Inc. , the parent company ofBethesda Softworks LLC , for$7.5 billion in cash. We expect this acquisition to close in the second half of fiscal year 2021, subject to customary closing conditions and completion of regulatory review. We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology, as well as continue making acquisitions that align with our business strategy. Additions to property and equipment will continue, including new facilities, datacenters, and computer systems for research and development, sales and marketing, support, and administrative staff. We expect capital expenditures to increase in coming years to support growth in our cloud offerings. We have operating and finance leases for datacenters, corporate offices, research and development facilities,Microsoft Experience Centers, and certain equipment. We have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of capital resources. 43 --------------------------------------------------------------------------------
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Liquidity
As a result of the TCJA, we are required to pay a one-time transition tax on
deferred foreign income not previously subject to U.S. income tax. Under the
TCJA, the transition tax is payable in interest-free installments over eight
years, with 8% due in each of the first five years, 15% in year six, 20% in year
seven, and 25% in year eight. We have paid transition tax of $4.7 billion , which
included $1.5 billion during the six months ended December 31, 2020 . The
remaining transition tax of $13.5 billion is payable over the next five years
with a final payment in fiscal year 2026.
We expect existing cash, cash equivalents, short-term investments, cash flows
from operations, and access to capital markets to continue to be sufficient to
fund our operating activities and cash commitments for investing and financing
activities, such as dividends, share repurchases, debt maturities, material
capital expenditures, and the transition tax related to the TCJA, for at least
the next 12 months and thereafter for the foreseeable future.
RECENT ACCOUNTING GUIDANCERefer to Note 1 - Accounting Policies of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion.
APPLICATION OF CRITICAL ACCOUNTING POLICIES
Our consolidated financial statements and accompanying notes are prepared in
accordance with GAAP. Preparing consolidated financial statements requires
management to make estimates and assumptions that affect the reported amounts of
assets, liabilities, revenue, and expenses. These estimates and assumptions are
affected by management's application of accounting policies, as well as
uncertainty in the current economic environment due to COVID-19. Critical
accounting policies for us include revenue recognition, impairment of investment
securities, goodwill, research and development costs, contingencies, income
taxes, and inventories.
Revenue Recognition
Our contracts with customers often include promises to transfer multiple
products and services to a customer. Determining whether products and services
are considered distinct performance obligations that should be accounted for
separately versus together may require significant judgment. When a cloud-based
service includes both on-premises software licenses and cloud services, judgment
is required to determine whether the software license is considered distinct and
accounted for separately, or not distinct and accounted for together with the
cloud service and recognized over time. Certain cloud services, primarily Office
365, depend on a significant level of integration, interdependency, and
interrelation between the desktop applications and cloud services, and are
accounted for together as one performance obligation. Revenue from Office 365 is
recognized ratably over the period in which the cloud services are provided.
Judgment is required to determine the SSP for each distinct performance
obligation. We use a single amount to estimate SSP for items that are not sold
separately, including on-premises licenses sold with SA or software updates
provided at no additional charge. We use a range of amounts to estimate SSP when
we sell each of the products and services separately and need to determine
whether there is a discount to be allocated based on the relative SSP of the
various products and services.
In instances where SSP is not directly observable, such as when we do not sell
the product or service separately, we determine the SSP using information that
may include market conditions and other observable inputs. We typically have
more than one SSP for individual products and services due to the stratification
of those products and services by customers and circumstances. In these
instances, we may use information such as the size of the customer and
geographic region in determining the SSP.
Due to the various benefits from and the nature of our SA program, judgment is
required to assess the pattern of delivery, including the exercise pattern of
certain benefits across our portfolio of customers.
Our products are generally sold with a right of return, we may provide other
credits or incentives, and in certain instances we estimate customer usage of
our products and services, which are accounted for as variable consideration
when determining the amount of revenue to recognize. Returns and credits are
estimated at contract inception and updated at the end of each reporting period
if additional information becomes available. Changes to our estimated variable
consideration were not material for the periods presented.
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Impairment of
We review debt investments quarterly for credit losses and impairment. If the cost of an investment exceeds its fair value, we evaluate, among other factors, general market conditions, credit quality of debt instrument issuers, and the extent to which the fair value is less than cost. This determination requires significant judgment. In making this judgment, we employ a systematic methodology that considers available quantitative and qualitative evidence in evaluating potential impairment of our investments. In addition, we consider specific adverse conditions related to the financial health of, and business outlook for, the investee. If we have plans to sell the security or it is more likely than not that we will be required to sell the security before recovery, then a decline in fair value below cost is recorded as an impairment charge in other income (expense), net and a new cost basis in the investment is established. If market, industry, and/or investee conditions deteriorate, we may incur future impairments. Equity investments without readily determinable fair values are written down to fair value if a qualitative assessment indicates that the investment is impaired and the fair value of the investment is less than carrying value. We perform a qualitative assessment on a periodic basis. We are required to estimate the fair value of the investment to determine the amount of the impairment loss. Once an investment is determined to be impaired, an impairment charge is recorded in other income (expense), net.Goodwill We allocate goodwill to reporting units based on the reporting unit expected to benefit from the business combination. We evaluate our reporting units on an annual basis and, if necessary, reassign goodwill using a relative fair value allocation approach.Goodwill is tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (May 1 for us) and between annual tests if an event occurs or circumstances change that would more likely than not reduce the fair value of a reporting unit below its carrying value. These events or circumstances could include a significant change in the business climate, legal factors, operating performance indicators, competition, or sale or disposition of a significant portion of a reporting unit. Application of the goodwill impairment test requires judgment, including the identification of reporting units, assignment of assets and liabilities to reporting units, assignment of goodwill to reporting units, and determination of the fair value of each reporting unit. The fair value of each reporting unit is estimated primarily through the use of a discounted cash flow methodology. This analysis requires significant judgments, including estimation of future cash flows, which is dependent on internal forecasts, estimation of the long-term rate of growth for our business, estimation of the useful life over which cash flows will occur, and determination of our weighted average cost of capital. The estimates used to calculate the fair value of a reporting unit change from year to year based on operating results, market conditions, and other factors. Changes in these estimates and assumptions could materially affect the determination of fair value and goodwill impairment for each reporting unit.
Research and Development Costs
Costs incurred internally in researching and developing a computer software product are charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, software costs are capitalized until the product is available for general release to customers. Judgment is required in determining when technological feasibility of a product is established. We have determined that technological feasibility for our software products is reached after all high-risk development issues have been resolved through coding and testing. Generally, this occurs shortly before the products are released to production. The amortization of these costs is included in cost of revenue over the estimated life of the products.
Legal and Other Contingencies
The outcomes of legal proceedings and claims brought against us are subject to
significant uncertainty. An estimated loss from a loss contingency such as a
legal proceeding or claim is accrued by a charge to income if it is probable
that an asset has been impaired or a liability has been incurred and the amount
of the loss can be reasonably estimated. In determining whether a loss should be
accrued we evaluate, among other factors, the degree of probability of an
unfavorable outcome and the ability to make a reasonable estimate of the amount
of loss. Changes in these factors could materially impact our consolidated
financial statements.
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Income Taxes
The objectives of accounting for income taxes are to recognize the amount of
taxes payable or refundable for the current year, and deferred tax liabilities
and assets for the future tax consequences of events that have been recognized
in an entity's financial statements or tax returns. We recognize the tax benefit
from an uncertain tax position only if it is more likely than not that the tax
position will be sustained on examination by the taxing authorities, based on
the technical merits of the position. The tax benefits recognized in the
financial statements from such a position are measured based on the largest
benefit that has a greater than 50% likelihood of being realized upon ultimate
settlement. Accounting literature also provides guidance on derecognition of
income tax assets and liabilities, classification of deferred income tax assets
and liabilities, accounting for interest and penalties associated with tax
positions, and income tax disclosures. Judgment is required in assessing the
future tax consequences of events that have been recognized in our consolidated
financial statements or tax returns. Variations in the actual outcome of these
future tax consequences could materially impact our consolidated financial
statements.
Inventories
Inventories are stated at average cost, subject to the lower of cost or net
realizable value. Cost includes materials, labor, and manufacturing overhead
related to the purchase and production of inventories. Net realizable value is
the estimated selling price less estimated costs of completion, disposal, and
transportation. We regularly review inventory quantities on hand, future
purchase commitments with our suppliers, and the estimated utility of our
inventory. These reviews include analysis of demand forecasts, product life
cycle status, product development plans, current sales levels, pricing strategy,
and component cost trends. If our review indicates a reduction in utility below
carrying value, we reduce our inventory to a new cost basis through a charge to
cost of revenue.
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Item 3, 4© Edgar Online, source
