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, 2019 , 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.
Highlights from the second quarter of fiscal year 2020 compared with the second quarter of fiscal year 2019 included:
• Commercial cloud revenue, which includes Microsoft Office 365 Commercial,
365, and other commercial cloud properties, increased 39% to $12.5
billion .
• Office Commercial revenue increased 16%, driven by Office 365 Commercial
growth of 27%.
• Office Consumer revenue increased 19%, and Office 365 Consumer subscribers
increased to 37.2 million.
• LinkedIn revenue increased 24%.
• Dynamics revenue increased 12%, driven by Dynamics 365 growth of 42%.
• Server products and cloud services revenue increased 30%, driven by Azure
growth of 62%.
• Enterprise Services revenue increased 6%.
• Windows original equipment manufacturer licensing ("Windows OEM") revenue
increased 18%.
• Windows Commercial revenue increased 25%.
• Search advertising revenue, excluding traffic acquisition costs, increased
6%.
• Microsoft Surface revenue increased 6%.
• Xbox content and services revenue decreased 11%.
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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. Strengthening of theU.S. dollar relative to certain foreign currencies reduced reported revenue and expenses from our international operations in the first and second quarter of fiscal year 2020.
Refer to Risk Factors (Part II, Item 1A of this Form 10-Q) for a discussion of these factors and other risks.
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.
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 16 - Segment Information and Geographic Data of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q).
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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
2019 2018 2019 2018
Revenue $ 36,906 $ 32,471 14% $ 69,961 $ 61,555 14%
Gross margin 24,548 20,048 22% 47,197 39,227 20%
Operating income 13,891 10,258 35% 26,577 20,213 31%
Net income 11,649 8,420 38% 22,327 17,244 29%
Diluted earnings per share 1.51 1.08 40% 2.90 2.22 31%
Non-GAAP net income 11,649 8,577 36% 22,327 17,401 28%
Non-GAAP diluted earnings
per share 1.51 1.10 37% 2.90 2.24 29%
Non-GAAP net income and diluted earnings per share ("EPS") exclude the net
charge related to the Tax Cuts and Jobs Act ("TCJA") of
The financial results of
Three Months Ended
Revenue increased$4.4 billion or 14%, 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 and LinkedIn. More Personal Computing revenue increased, driven by Windows, offset in part by a decrease in Gaming. Gross margin increased$4.5 billion or 22%, driven by growth across each of our segments. Gross margin percentage increased, driven by sales mix shift to higher margin businesses. Gross margin included a 5-point improvement in commercial cloud, primarily from Azure.
Operating income increased
Key changes in expenses were:
• Cost of revenue decreased
Gaming, offset in part by growth in commercial cloud.
• Research and development expenses increased
investments in cloud engineering, LinkedIn, and Gaming.
• Sales and marketing expenses increased $345 million or 8%, driven by
investments in LinkedIn and commercial sales.
• General and administrative expenses decreased $11 million or 1%.
Gross margin and operating income included an unfavorable foreign currency impact of 3% and 4%, respectively.
Prior year net income and diluted EPS were negatively impacted by the net charge related to the TCJA, which resulted in a decrease to net income and diluted EPS of$157 million and$0.02 , respectively.
Six Months Ended
Revenue increased$8.4 billion or 14%, 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 and LinkedIn. More Personal Computing revenue increased, driven by Windows, offset in part by a decrease in Gaming. 33 --------------------------------------------------------------------------------
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Gross margin increased $8.0 billion or 20%, driven by growth across each of our
segments. Gross margin percentage increased, driven by sales mix shift to higher
margin businesses. Gross margin included a 5-point improvement in commercial
cloud, primarily from Azure.
Operating income increased
Key changes in expenses were:
• Cost of revenue increased $436 million or 2%, driven by growth in
commercial cloud, offset in part by a decline in Gaming.
• Research and development expenses increased
investments in cloud engineering, LinkedIn, Gaming, and GitHub .
• Sales and marketing expenses increased $584 million or 7%, driven by
investments in LinkedIn and commercial sales.
• General and administrative expenses decreased $99 million or 4%.
Gross margin and operating income included an unfavorable foreign currency impact of 3% and 5%, respectively.
Prior year net income and diluted EPS were negatively impacted by the net charge related to the TCJA, which resulted in a decrease to net income and diluted EPS of$157 million and$0.02 , respectively. SEGMENT RESULTS OF OPERATIONS (In millions, except Three Months Ended Percentage Six Months Ended Percentage percentages) December 31, Change December 31, Change 2019 2018 2019 2018 Revenue Productivity and Business Processes$ 11,826 $ 10,100 17%$ 22,903 $ 19,871 15% Intelligent Cloud 11,869 9,378 27% 22,714 17,945 27% More Personal Computing 13,211 12,993 2% 24,344 23,739 3% Total$ 36,906 $ 32,471 14%$ 69,961 $ 61,555 14% Operating Income Productivity and Business Processes$ 5,182 $ 4,015 29%$ 9,964 $ 7,896 26% Intelligent Cloud 4,531 3,279 38% 8,420 6,210 36% More Personal Computing 4,178 2,964 41% 8,193 6,107 34% Total$ 13,891 $ 10,258 35%$ 26,577 $ 20,213 31% Reportable Segments
Three Months Ended
Productivity and Business Processes
Revenue increased
• Office Commercial revenue increased
365 Commercial growth of 27%, due to growth in seats and revenue per user.
• Office Consumer revenue increased
365 recurring subscription revenue and transactional strength in
well as a benefit from a low prior year comparable.
• LinkedIn revenue increased
strength across all businesses.
• Dynamics revenue increased 12%, driven by Dynamics 365 growth of 42%.
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Operating income increased
• Gross margin increased
Commercial and LinkedIn. Gross margin percentage increased, due to gross
margin percentage improvement in Office 365 Commercial and LinkedIn,
offset in part by an increased mix of cloud offerings.
• Operating expenses increased
LinkedIn and cloud engineering.
Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 2%, 2%, and 4%, respectively.
Intelligent Cloud
Revenue increased
• Server products and cloud services revenue increased
driven by Azure. Azure revenue grew 62%, due to higher
infrastructure-as-a-service and platform-as-a-service consumption-based
services and per user-based services. Server products revenue increased
10%, due to hybrid and premium solutions, as well as demand related to
Windows Server 2008 end of support.
• Enterprise Services revenue increased
in
Operating income increased
• Gross margin increased $1.8 billion or 28%, driven by growth in server
products and cloud services revenue and cloud services scale and
efficiencies. Gross margin percentage increased, due to gross margin
percentage improvement in Azure, offset in part by an increased mix of
cloud offerings.
• Operating expenses increased
Azure.
Gross margin and operating income included an unfavorable foreign currency impact of 3% and 4%, respectively.
More Personal Computing
Revenue increased
• Windows revenue increased
OEM and Windows Commercial. Windows OEM revenue increased 18%, ahead of PC
market growth that was impacted in the prior year by chip supply
constraints. Windows OEM Pro revenue grew 26%, driven by continued
momentum in advance of Windows 7 end of support and healthy Windows 10demand, in addition to the benefit from the low prior year comparable.
Windows OEM non-Pro revenue grew 4%, driven by the benefit from the low
prior year comparable and the timing of license purchases, offset in part
by continued pressure in the entry-level category. Windows Commercial
revenue increased 25%, primarily driven by an increase in Microsoft 365
agreements, which carry higher in-quarter revenue recognition.
• Search advertising revenue increased $187 million or 9%. Search
advertising revenue, excluding traffic acquisition costs, increased 6%,
driven by higher revenue per search.
• Surface revenue increased $116 million or 6%, driven by commercial growth.
• Gaming revenue decreased $905 million or 21%. Xbox hardware revenuedecreased 43%, primarily due to a decrease in volume and price of consoles
sold. Xbox content and services revenue decreased $295 million or 11%,
against a high prior year comparable primarily from a third-party title,
offset in part by growth in subscriptions.
Operating income increased
• Gross margin increased
and Surface. Gross margin percentage increased, due to sales mix shift to
higher margin businesses.
• Operating expenses decreased $150 million or 5%, driven by theredeployment of engineering resources, offset in part by investments in
Gaming, primarily in first-party content.
Gross margin and operating income included an unfavorable foreign currency impact of 2% and 4%, respectively.
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Six Months Ended
Productivity and Business Processes
Revenue increased
• Office Commercial revenue increased
365 Commercial growth of 26%, due to growth in seats and revenue per user.
• Office Consumer revenue increased $241 million or 12%, driven by Office
365 recurring subscription revenue and transactional strength in Japan .
• LinkedIn revenue increased
strength across all businesses.
• Dynamics revenue increased 13%, driven by Dynamics 365 growth of 41%.
Operating income increased
• Gross margin increased
Commercial and LinkedIn. Gross margin percentage increased, due to gross
margin percentage improvement in LinkedIn and Office 365 Commercial,
offset in part by an increased mix of cloud offerings.
• Operating expenses increased
LinkedIn and cloud engineering.
Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 2%, 2%, and 4%, respectively.
Intelligent Cloud
Revenue increased
• Server products and cloud services revenue increased
driven by Azure. Azure revenue grew 61%, due to higher
infrastructure-as-a-service and platform-as-a-service consumption-based
services and per user-based services. Server products revenue increased
11%, due to hybrid and premium solutions, demand related to
Server 2008 and Windows Server 2008 end-of-support, and
• Enterprise Services revenue increased
in
Operating income increased
• Gross margin increased $3.4 billion or 28%, driven by growth in server
products and cloud services revenue and cloud services scale and
efficiencies. Gross margin percentage increased slightly, due to grossmargin percentage improvement in Azure, offset in part by an increased mix
of cloud offerings.
• Operating expenses increased
Azure, as well as
Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 2%, 2%, and 4%, respectively.
More Personal Computing
Revenue increased
• Windows revenue increased
OEM and Windows Commercial. Windows OEM revenue increased 13%, ahead of PC
market growth that was impacted in the prior year by chip supply
constraints. Windows OEM Pro revenue grew 22%, driven by continued
momentum in advance of Windows 7 end of support and healthy Windows 10demand, in addition to the benefit from the low prior year comparable.
Windows OEM non-Pro revenue declined 1%, driven by continued pressure in
the entry-level category, offset in part by the benefit from the low prior
year comparable. Windows Commercial revenue increased 26%, driven by an
increase in Microsoft 365 agreements, which carry higher in-quarter
revenue recognition.
• Search advertising revenue increased $390 million or 10%. Search
advertising revenue, excluding traffic acquisition costs, increased 8%,
driven by higher revenue per search.
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• Surface revenue increased $72 million or 2%, driven by commercial growth,offset in part by a decline in consumer.
• Gaming revenue decreased
hardware of 40%, primarily due to a decrease in volume and price of
consoles sold. Xbox content and services revenue decreased
6%, against a high prior year comparable primarily from a third-party
title, offset in part by growth in subscriptions.
Operating income increased
• Gross margin increased
Gross margin percentage increased, due to sales mix shift to higher margin
businesses.
• Operating expenses decreased $334 million or 6%, driven by the
redeployment of engineering resources.
Gross margin and operating income included an unfavorable foreign currency impact of 2% and 3%, respectively.
OPERATING EXPENSES
Research and Development
(In millions, except Three Months Ended Percentage Six Months Ended Percentage
percentages) December 31, Change December 31, Change
2019 2018 2019 2018
Research and development $ 4,603 $ 4,070 13% $ 9,168 $ 8,047 14%
As a percent of revenue 12% 13% (1)ppt 13% 13% 0ppt
Research and development expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with product development. Research and development expenses also include third-party development and programming costs, localization costs incurred to translate software for international markets, and the amortization of purchased software code and services content.
Three Months Ended
Research and development expenses increased
Six Months Ended
Research and development expenses increased
Sales and Marketing
(In millions, except Three Months Ended Percentage Six Months Ended Percentage
percentages) December 31, Change December 31, Change
2019 2018 2019 2018
Sales and marketing $ 4,933 $ 4,588 8% $ 9,270 $ 8,686 7%
As a percent of revenue 13% 14% (1)ppt 13% 14% (1)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 increased
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Six Months Ended
Sales and marketing expenses increased
General and Administrative
(In millions, except Three Months Ended Percentage Six Months Ended Percentage
percentages) December 31, Change December 31, Change
2019 2018 2019 2018
General and
administrative $ 1,121 $ 1,132 (1)% $ 2,182 $ 2,281 (4)%
As a percent of revenue 3% 3% 0ppt 3% 4% (1)ppt
General and administrative expenses include payroll, employee benefits,
stock-based compensation expense, severance expense, and other headcount-related
expenses associated with finance, legal, facilities, certain human resources and
other administrative personnel, certain taxes, and legal and other
administrative fees.
Three Months Ended
General and administrative expenses decreased
Six Months Ended
General and administrative expenses decreased
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,
2019 2018 2019 2018
Interest and dividends income $ 688 $ 704 $ 1,412 $ 1,385
Interest expense (654 ) (672 ) (1,291 ) (1,346 )
Net recognized gains on investments 162 94 105 337
Net gains on derivatives 41 41 87 38
Net losses on foreign currency remeasurements (24 ) (74 ) (82 ) (69 )
Other, net (19 ) 34 (37 ) 48
Total $ 194 $ 127 $ 194 $ 393 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 capitalization of interest expense
and a decrease in outstanding long-term debt due to debt maturities, offset in
part by higher finance lease expense. Net recognized gains on investments
increased due to higher gains on equity investments.
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Six Months Ended
Interest and dividends income increased due to higher average portfolio balances
on fixed-income securities. Interest expense decreased due to capitalization of
interest expense and a decrease in outstanding long-term debt due to debt
maturities, offset in part by higher finance lease expense. Net recognized gains
on investments decreased due to lower gains on equity investments. Net gains on
derivatives increased due to higher gains on foreign exchange derivatives.
INCOME TAXESEffective Tax Rate
Our effective tax rate was 17% and 19% for the three months endedDecember 31, 2019 and 2018, respectively, and 17% and 16% for the six months endedDecember 31, 2019 and 2018, respectively. The decrease in our effective tax rate for the three months endedDecember 31, 2019 compared to the prior year was primarily due to the adjustment of the provisional net charge related to the TCJA in the second quarter of fiscal year 2019. The increase in our effective tax rate for the six months endedDecember 31, 2019 compared to the prior year was primarily due to changes in the mix of our income before income taxes between theU.S. and foreign countries, offset in part by the adjustment of the provisional net charge related to the TCJA. Our effective tax rate was lower than theU.S. federal statutory rate for the three and six months endedDecember 31, 2019 , 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. In February 2012 , the IRS 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
the IRS audit for tax years 2007 to 2009 in fiscal year 2016, and a portion of
the IRS audit for tax years 2010 to 2013 in fiscal year 2018. We remain under
audit for tax years 2004 to 2013. We expect the IRS to begin an examination of
tax years 2014 to 2017 within the next 12 months.
As of December 31, 2019 , the primary unresolved issues for the IRS 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 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 the U.S. Our
operations in certain jurisdictions remain subject to examination for tax years
1996 to 2019, 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.
NON-GAAP FINANCIAL MEASURESNon-GAAP net income and diluted earnings per share are non-GAAP financial measures which exclude a net charge related to the TCJA. We believe these non-GAAP measures aid investors by providing additional insight into our operational performance and help clarify trends affecting our business. For comparability of reporting, management considers non-GAAP measures in conjunction with GAAP financial results in evaluating business performance. These non-GAAP financial measures presented should not be considered a substitute for, or superior to, the measures of financial performance prepared in accordance with GAAP.
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The following table reconciles our financial results reported in accordance with GAAP to non-GAAP financial results:
(In millions, except percentages and per share Three Months Ended Percentage Six Months Ended Percentage
amounts) December 31, Change December 31, Change
2019 2018 2019 2018
Net income $ 11,649 $ 8,420 38% $ 22,327 $ 17,244 29%
Net charge related to the TCJA 0 157 * 0 157 *
Non-GAAP net income $ 11,649 $ 8,577 36% $ 22,327 $ 17,401 28%
Diluted earnings per share $ 1.51 $ 1.08 40% $ 2.90 $ 2.22 31%
Net charge related to the TCJA 0 0.02 * 0 0.02 *
Non-GAAP diluted earnings per share $ 1.51 $ 1.10 37% $ 2.90 $ 2.24 29%
* Not meaningful.
FINANCIAL CONDITION
Cash, Cash Equivalents, and Investments
Cash, cash equivalents, and short-term investments totaled$134.3 billion and$133.8 billion as ofDecember 31, 2019 andJune 30, 2019 . Equity investments were$2.8 billion and$2.6 billion as ofDecember 31, 2019 andJune 30, 2019 , 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.
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 asU.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. 40 --------------------------------------------------------------------------------
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Cash Flows
Cash from operations increased $1.9 billion to $24.5 billion for the six months
ended December 31, 2019 , mainly due to an increase in cash from customers,
offset in part by an increase in cash used to pay suppliers, income taxes, and
employees. Cash used in financing decreased $1.5 billion to $19.1 billion for
the six months ended December 31, 2019 , mainly due to other financing to
facilitate the purchase of components. Cash used in investing increased $659
million to $7.8 billion for the six months ended December 31, 2019 , mainly due
to a $2.3 billion increase in cash used for net investment purchases, sales, and
maturities, offset in part by a $1.3 billion decrease in cash used for
acquisition of companies, net of cash acquired, and purchases of intangible and
other assets.
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. Our last debt issuance occurred in fiscal year 2017. Refer to
Note 9 - 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.
The following table outlines the expected future recognition of unearned revenue
as of
(In millions) Three Months EndingMarch 31, 2020 $ 12,879 June 30, 2020 8,287 September 30, 2020 3,871 December 31, 2020 2,306 Thereafter 3,878 Total$ 31,221
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, 2019 and 2018, we repurchased 61 million shares and 81 million shares of our common stock for$8.6 billion and$8.7 billion , respectively, through our share repurchase program. All repurchases were made using cash resources. Refer to Note 14 - Stockholders' Equity of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion. Dividends
Refer to Note 14 - Stockholders' Equity of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion.
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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
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, retail stores, and certain equipment. We have not engaged in any related party transactions or arrangements with unconsolidated entities or other persons that are reasonably likely to materially affect liquidity or the availability of capital resources.
Liquidity
As a result of the TCJA, we are required to pay a one-time transition tax on deferred foreign income not previously subject toU.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$3.2 billion , which included$1.2 billion during the six months endedDecember 31, 2019 . The remaining transition tax of$15.2 billion is payable over the next six years with a final payment in fiscal year 2026. During the six months endedDecember 31, 2019 , we also paid$3.7 billion related to the transfer of intangible properties that occurred in the fourth quarter of fiscal year 2019. 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 GUIDANCE
Refer 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. Critical accounting
policies for us include revenue recognition, impairment of investment
securities, goodwill, research and development costs, contingencies, income
taxes, and inventories.
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Item 2
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 stand-alone selling price ("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.
Impairment of
We review debt investments quarterly for indicators of other-than-temporary
impairment. This determination requires significant judgment. In making this
judgment, we employ a systematic methodology quarterly that considers available
quantitative and qualitative evidence in evaluating potential impairment of our
investments. If the cost of an investment exceeds its fair value, we evaluate,
among other factors, general market conditions, credit quality of debt
instrument issuers, and the duration and extent to which the fair value is less
than cost. We also evaluate whether we have plans to sell the security or it is
more likely than not that we will be required to sell the security before
recovery. In addition, we consider specific adverse conditions related to the
financial health of and business outlook for the investee, including industry
and sector performance, changes in technology, and operational and financing
cash flow factors. Once a decline in fair value is determined to be
other-than-temporary, an impairment charge is recorded 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 quarterly 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.
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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.
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.
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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
