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MICROSOFT CORP MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS (form 10-Q)

04/26/2022 | 04:14pm EDT

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, 2021, 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 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 third quarter of fiscal year 2022 compared with the third quarter of fiscal year 2021 included:

• Microsoft Cloud (formerly commercial cloud) revenue increased 32% to $23.4

billion.

• Office Commercial products and cloud services revenue increased 12% driven

by Office 365 Commercial growth of 17%.

• Office Consumer products and cloud services revenue increased 11% and

        Microsoft 365 Consumer subscribers grew to 58.4 million.


  • LinkedIn revenue increased 34%.


     •  Dynamics products and cloud services revenue increased 22% driven by
        Dynamics 365 growth of 35%.

• Server products and cloud services revenue increased 29% driven by Azure

and other cloud services growth of 46%.

• Windows original equipment manufacturer licensing ("Windows OEM") revenue

        increased 11%.


  • Windows Commercial products and cloud services revenue increased 14%.


  • Xbox content and services revenue increased 4%.


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                                     PART I
                                     Item 2


     •  Search and news advertising revenue excluding traffic acquisition costs
        increased 23%.


  • Surface revenue increased 13%.


On March 4, 2022, we completed our acquisition of Nuance Communications, Inc.
("Nuance") for a total purchase price of $18.8 billion, consisting primarily of
cash. Nuance is a cloud and artificial intelligence ("AI") software provider
with healthcare and enterprise AI experience, and the acquisition will build on
our industry-specific cloud offerings. The financial results of Nuance have been
included in our consolidated financial statements since the date of the
acquisition. Nuance is reported as part of our Intelligent Cloud segment. Refer
to Note 7 - Business Combinations of the Notes to the Financial Statements (Part
I, Item 1 of this Form 10-Q) for further discussion.

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 devices are primarily manufactured by third-party contract manufacturers,
some of which contain certain components for which there are very few qualified
suppliers. For these components, we have limited near-term flexibility to use
other manufacturers if a current vendor becomes unavailable or is unable to meet
our requirements. Extended disruptions at these suppliers could lead to a
similar disruption in our ability to manufacture devices on time to meet
consumer demand.

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 the U.S. dollar. As a result, changes in foreign exchange rates may
significantly affect revenue and expenses. Fluctuations in the U.S. dollar
relative to certain foreign currencies reduced reported revenue and expenses
from our international operations for the three months ended March 31, 2022, and
did not have a material impact on reported revenue or expenses from our
international operations for the nine months ended March 31, 2022.

Refer to Risk Factors (Part II, Item 1A of this Form 10-Q) for a discussion of these factors and other risks.

COVID-19


The COVID-19 pandemic continues to impact our business operations and financial
results, although some of the effects have lessened over time. Our commercial
and consumer businesses have benefited from demand for cloud and productivity
tools, and we have experienced 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 a discussion of these factors and other risks.

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                                     Item 2


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
in the 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.

In the first quarter of fiscal year 2022, we made updates to the presentation
and method of calculation for certain metrics, most notably changes to
incorporate all current and anticipated revenue streams within our Office
Consumer and Server products and cloud services metrics and changes to align
with how we manage our Windows OEM and Search and news advertising businesses.
None of these changes had a material impact on previously reported amounts in
our MD&A.

In the third quarter of fiscal year 2022, we completed our acquisition of
Nuance. Nuance is included in all commercial metrics and our Server products and
cloud services revenue growth metric. Azure and other cloud services revenue
includes Nuance cloud services, and Server products revenue includes Nuance
on-premises offerings.

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

Microsoft Cloud revenue                       Revenue from our commercial cloud business,
                                              which includes Azure and other cloud services,
                                              Office 365 Commercial, the commercial portion of
                                              LinkedIn, Dynamics 365, and other commercial
                                              cloud properties

Microsoft Cloud gross margin percentage       Gross margin percentage for our commercial cloud
                                              business




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                                     Item 2


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 (Office 365 subscriptions, the

                                                               Office 365 

portion of Microsoft 365 Commercial

subscriptions, and Office licensed on-premises),

                                                               comprising 

Office, Exchange, SharePoint,

                                                               Microsoft 

Teams, Office 365 Security and

                                                               Compliance, 

and Skype for Business

Office Consumer products and cloud services revenue growth Revenue from Office Consumer products and cloud

                                                               services, 

including Microsoft 365 Consumer

subscriptions, Office licensed on-premises, and

                                                               other Office 

services


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 Microsoft 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, Customer Insights, Power Apps,

                                                               and Power 

Automate; and on-premises ERP and CRM

                                                               applications

LinkedIn revenue growth                                        Revenue from LinkedIn, including Talent
                                                               Solutions,

Marketing Solutions, Premium

Subscriptions, Sales Solutions, and Learning

                                                               Solutions

Server products and cloud services revenue growth              Revenue from 

Server products and cloud services,

                                                               including 

Azure and other cloud services; SQL

                                                               Server, 

Windows Server, Visual Studio, System

                                                               Center, and 

related Client Access Licenses

                                                               ("CALs"); and Nuance 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 revenue growth                                      Revenue 

from sales of Windows Pro and non-Pro

                                                                licenses 

sold through the OEM channel

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 growth                                          Revenue 

from Surface devices and accessories


Xbox content and services revenue growth                        Revenue 

from Xbox content and services,

                                                                comprising 

digital transactions, Xbox Game Pass

                                                                and other subscriptions, video games,
                                                                third-party video game royalties, cloud
                                                                services, and advertising

Search and news advertising revenue, excluding TAC, growth Revenue from search and news advertising

                                                                excluding 

traffic acquisition costs ("TAC") paid

                                                                to Bing Ads 

network publishers and news partners

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                                     PART I
                                     Item 2



                         SUMMARY RESULTS OF OPERATIONS

(In millions, except percentages and per share             Three Months Ended        Percentage               Nine Months Ended        Percentage
amounts)                                                            March 31,            Change                       March 31,            Change


                                                        2022             2021                              2022            2021

Revenue                                          $    49,360      $    41,706               18%     $   146,405     $   121,936               20%
Gross margin                                          33,745           28,661               18%         100,184          83,695               20%
Operating income                                      20,364           17,048               19%          62,849          50,821               24%
Net income                                            16,728           15,457                8%          55,998          44,813               25%
Diluted earnings per share                              2.22             2.03                9%            7.41            5.88               26%

Adjusted net income (non-GAAP)                        16,728           14,837               13%          52,707          44,193               19%
Adjusted diluted earnings per share (non-GAAP)          2.22             1.95               14%            6.98            5.80               20%



Adjusted net income and adjusted diluted earnings per share ("EPS") are non-GAAP
financial measures which exclude the net income tax benefit related to transfer
of intangible properties in the first quarter of fiscal year 2022 and the net
income tax benefit related to an India Supreme Court decision on withholding
taxes in the third quarter of fiscal year 2021. Refer to the Non-GAAP Financial
Measures section below for a reconciliation of our financial results reported in
accordance with GAAP to non-GAAP financial results. Refer to Note 11 - Income
Taxes of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q)
for further discussion.

Three Months Ended March 31, 2022 Compared with Three Months Ended March 31, 2021


Revenue increased $7.7 billion or 18% driven by growth across each of our
segments. Intelligent Cloud revenue increased driven by Azure and other cloud
services. Productivity and Business Processes revenue increased driven by Office
365 Commercial and LinkedIn. More Personal Computing revenue increased driven by
Windows and Search and news advertising.

Cost of revenue increased $2.6 billion or 20% driven by growth in Microsoft Cloud.

Gross margin increased $5.1 billion or 18% driven by growth across each of our segments.

     •  Gross margin percentage decreased slightly. Excluding the impact of the
        change in accounting estimate for the useful lives of our server and
        network equipment, gross margin percentage increased 1 point driven by
        improvements in Productivity and Business Processes and Intelligent Cloud.

• Microsoft Cloud gross margin percentage decreased slightly to 70%.

Excluding the impact of the change in accounting estimate, Microsoft Cloud

        gross margin percentage increased 3 points driven by improvement across
        our cloud services, offset in part by sales mix shift to Azure and other
        cloud services.

Operating expenses increased $1.8 billion or 15% driven by investments in cloud engineering, LinkedIn, and commercial sales.

Key changes in operating expenses were:

• Research and development expenses increased $1.1 billion or 21% driven by

        investments in cloud engineering.


     •  Sales and marketing expenses increased $513 million or 10% driven by

investments in commercial sales and LinkedIn. Sales and marketing included

a favorable foreign currency impact of 3%.

• General and administrative expenses increased $153 million or 12% driven

by investments in corporate functions. General and administrative included

a favorable foreign currency impact of 2%.

Operating income increased $3.3 billion or 19% driven by growth across each of our segments.


Prior year net income and diluted EPS were positively impacted by the tax
benefit related to the India Supreme Court decision on withholding taxes, which
resulted in an increase to net income and diluted EPS of $620 million and $0.08,
respectively.

Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 3%, 3%, and 4%, respectively. Operating expenses included a favorable foreign currency impact of 2%.

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                                     PART I
                                     Item 2

Nine Months Ended March 31, 2022 Compared with Nine Months Ended March 31, 2021


Revenue increased $24.5 billion or 20% driven by growth across each of our
segments. Intelligent Cloud revenue increased driven by Azure and other cloud
services. Productivity and Business Processes revenue increased driven by Office
365 Commercial and LinkedIn. More Personal Computing revenue increased driven by
Windows, Search and news advertising, and Gaming.

Cost of revenue increased $8.0 billion or 21% driven by growth in Microsoft Cloud.

Gross margin increased $16.5 billion or 20% driven by growth across each of our segments.

     •  Gross margin percentage decreased slightly. Excluding the impact of the
        change in accounting estimate, gross margin percentage increased 2 points
        driven by improvements across each of our segments.

• Microsoft Cloud gross margin percentage decreased slightly to 70%.

Excluding the impact of the change in accounting estimate, Microsoft Cloud

        gross margin percentage increased 3 points driven by improvement across
        our cloud services, offset in part by sales mix shift to Azure and other
        cloud services.

Operating expenses increased $4.5 billion or 14% driven by investments in cloud engineering, LinkedIn, Gaming, and commercial sales.

Key changes in operating expenses were:

• Research and development expenses increased $2.6 billion or 18% driven by

        investments in cloud engineering and Gaming.


     •  Sales and marketing expenses increased $1.3 billion or 9% driven by
        investments in commercial sales, LinkedIn, and Windows marketing.

• General and administrative expenses increased $566 million or 16% driven

by investments in corporate functions.

Operating income increased $12.0 billion or 24% driven by growth across each of our segments.


Current year net income and diluted EPS were positively impacted by the net tax
benefit related to the transfer of intangible properties, which resulted in an
increase to net income and diluted EPS of $3.3 billion and $0.43, respectively.
Prior year net income and diluted EPS were positively impacted by the net tax
benefit related to the India Supreme Court decision on withholding taxes, which
resulted in an increase to net income and diluted EPS of $620 million and $0.08,
respectively.

                         SEGMENT RESULTS OF OPERATIONS

(In millions, except               Three Months Ended       Percentage           Nine Months Ended       Percentage
percentages)                                March 31,           Change                   March 31,           Change


                                    2022         2021                           2022          2021

Revenue

Productivity and Business                                                                $
Processes                     $   15,789     $ 13,552              17%     $  46,764        39,224              19%
Intelligent Cloud                 19,051       15,118              26%        54,342        42,705              27%
More Personal Computing           14,520       13,036              11%        45,299        40,007              13%


Total                         $   49,360     $ 41,706              18%     $ 146,405     $ 121,936              20%


Operating Income

Productivity and Business                                                                $
Processes                     $    7,184     $  6,029              19%     $  22,453        17,916              25%
Intelligent Cloud                  8,281        6,425              29%        24,040        18,339              31%
More Personal Computing            4,899        4,594               7%        16,356        14,566              12%


Total                         $   20,364     $ 17,048              19%     $  62,849     $  50,821              24%





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                                     PART I
                                     Item 2



Reportable Segments

Three Months Ended March 31, 2022 Compared with Three Months Ended March 31, 2021

Productivity and Business Processes

Revenue increased $2.2 billion or 17%.

     •  Office Commercial products and cloud services revenue increased $999
        million or 12%. Office 365 Commercial revenue grew 17% driven by seat
        growth of 16%, with continued momentum in small and medium business and
        frontline worker offerings, as well as growth in revenue per user. Office

Commercial products revenue declined 28% driven by continued customer

shift to cloud offerings.

• Office Consumer products and cloud services revenue increased $150 million

or 11% driven by Microsoft 365 Consumer subscription revenue. Microsoft

        365 Consumer subscribers grew 16% to 58.4 million.


     •  LinkedIn revenue increased $875 million or 34% driven by a strong job
        market in our Talent Solutions business and advertising demand in our
        Marketing Solutions business.


     •  Dynamics products and cloud services revenue increased 22% driven by
        Dynamics 365 growth of 35%.

Operating income increased $1.2 billion or 19%.

• Gross margin increased $1.7 billion or 16% driven by growth in Office 365

Commercial and LinkedIn. Gross margin percentage was relatively unchanged.

        Excluding the impact of the change in accounting estimate, gross margin
        percentage increased 2 points driven by improvement across all cloud
        services.

• Operating expenses increased $565 million or 13% driven by investments in

LinkedIn and cloud engineering.

Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 2%, 3%, and 4%, respectively.

Intelligent Cloud

Revenue increased $3.9 billion or 26%.

• Server products and cloud services revenue increased $3.8 billion or 29%

driven by Azure and other cloud services. Azure and other cloud services

revenue grew 46% driven by growth in our consumption-based services.

Server products revenue increased 5% driven by hybrid solutions, including

Windows Server and SQL Server running in multi-cloud environments.

• Enterprise Services revenue increased $88 million or 5% driven by growth

in Enterprise Support Services.

Operating income increased $1.9 billion or 29%.

• Gross margin increased $2.6 billion or 24% driven by growth in Azure and

other cloud services. Gross margin percentage decreased. Excluding the

impact of the change in accounting estimate, gross margin percentage

increased 1 point driven by improvement in Azure and other cloud services,

offset in part by sales mix shift to Azure and other cloud services.

• Operating expenses increased $753 million or 17% driven by investments in

Azure and other cloud services.

Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 3%, 3%, and 4%, respectively. Operating expenses included a favorable foreign currency impact of 2%.

More Personal Computing

Revenue increased $1.5 billion or 11%.

• Windows revenue increased $614 million or 11% driven by growth in Windows

OEM and Windows Commercial. Windows OEM revenue increased 11% driven by

continued strength in the commercial PC market, which has higher revenue

        per license. Windows Commercial products and cloud services revenue
        increased 14% driven by demand for Microsoft 365.

• Search and news advertising revenue increased $544 million or 23%. Search

and news advertising revenue excluding traffic acquisition costs increased

23% driven by higher revenue per search and search volume.

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                                     PART I
                                     Item 2

     •  Gaming revenue increased $207 million or 6% on a strong prior year

comparable that benefited from Xbox Series X|S launches, driven by growth

in Xbox content and services and Xbox Hardware. Xbox content and services

revenue increased 4% driven by growth in Xbox Game Pass subscriptions and

first-party titles, offset in part by a decline in third-party titles.

Xbox hardware revenue increased 14% due to continued demand for Xbox

        Series X|S.


  • Surface revenue increased $195 million or 13%.

Operating income increased $305 million or 7%.

• Gross margin increased $755 million or 10% driven by growth in Windows and

Search and news advertising. Gross margin percentage decreased slightly.

• Operating expenses increased $450 million or 17% driven by investments in

Gaming, Search and news advertising, and Windows marketing.

Revenue, gross margin, and operating income included an unfavorable foreign currency impact of 2%, 3%, and 3%, respectively.

Nine Months Ended March 31, 2022 Compared with Nine Months Ended March 31, 2021

Productivity and Business Processes

Revenue increased $7.5 billion or 19%.

     •  Office Commercial products and cloud services revenue increased $3.5
        billion or 14%. Office 365 Commercial revenue grew 20% driven by seat
        growth of 16%, with continued momentum in small and medium business and
        frontline worker offerings, as well as growth in revenue per user. Office

Commercial products revenue declined 19% driven by continued customer

        shift to cloud offerings, on a low prior year comparable impacted by a
        slowdown in transactional licensing.

• Office Consumer products and cloud services revenue increased $505 million

or 12% driven by Microsoft 365 Consumer subscription revenue.



     •  LinkedIn revenue increased $2.8 billion or 38% driven by a strong job
        market in our Talent Solutions business and advertising demand in our
        Marketing Solutions business.

• Dynamics products and cloud services revenue increased 27% driven by

Dynamics 365 growth of 42%.

Operating income increased $4.5 billion or 25%.

• Gross margin increased $5.9 billion or 19% driven by growth in Office 365

Commercial and LinkedIn. Gross margin percentage was relatively unchanged.

        Excluding the impact of the change in accounting estimate, gross margin
        percentage increased 2 points driven by improvement across all cloud
        services.

• Operating expenses increased $1.4 billion or 11% driven by investments in

cloud engineering and LinkedIn.

Intelligent Cloud

Revenue increased $11.6 billion or 27%.

• Server products and cloud services revenue increased $11.4 billion or 31%

driven by Azure and other cloud services. Azure and other cloud services

revenue grew 47% driven by growth in our consumption-based services.

Server products revenue increased 8% driven by hybrid solutions, including

Windows Server and SQL Server running in multi-cloud environments.

• Enterprise Services revenue increased $370 million or 7% driven by growth

in Enterprise Support Services and Microsoft Consulting Services.

Operating income increased $5.7 billion or 31%.

• Gross margin increased $7.5 billion or 24% driven by growth in Azure and

other cloud services. Gross margin percentage decreased. Excluding the

impact of the change in accounting estimate, gross margin percentage

increased 1 point driven by improvement in Azure and other cloud services,

offset in part by sales mix shift to Azure and other cloud services.

• Operating expenses increased $1.8 billion or 15% driven by investments in

Azure and other cloud services.

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                                     PART I
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More Personal Computing

Revenue increased $5.3 billion or 13%.

• Windows revenue increased $2.2 billion or 14% driven by growth in Windows

OEM and Windows Commercial. Windows OEM revenue increased 16% driven by

continued strength in the commercial PC market, which has higher revenue

        per license. Windows Commercial products and cloud services revenue
        increased 13% driven by demand for Microsoft 365.

• Search and news advertising revenue increased $1.9 billion or 29%. Search

and news advertising revenue excluding traffic acquisition costs increased

31% driven by higher revenue per search.

• Gaming revenue increased $1.1 billion or 10% on a strong prior year

comparable that benefited from Xbox Series X|S launches and stay-at-home

scenarios, driven by growth in Xbox hardware and Xbox content and

services. Xbox hardware revenue increased 25% due to continued demand for

Xbox Series X|S. Xbox content and services revenue increased 6% driven by

growth in first-party titles and Xbox Game Pass subscriptions, offset in

        part by a decline in third-party titles.


  • Surface revenue increased $90 million or 2%.

Operating income increased $1.8 billion or 12%.

• Gross margin increased $3.0 billion or 14% driven by growth in Windows and

Search and news advertising. Gross margin percentage increased slightly

driven by sales mix shift to higher margin businesses and improvement in

Search and news advertising.

• Operating expenses increased $1.3 billion or 16% driven by investments in

        Gaming, Windows marketing, and Search and news advertising.


                               OPERATING EXPENSES

Research and Development

(In millions, except                Three Months Ended      Percentage          Nine Months Ended      Percentage
percentages)                                 March 31,          Change                  March 31,          Change


                                    2022          2021                          2022         2021

Research and development      $    6,306      $  5,204             21%     $  17,663     $ 15,029             18%
As a percent of revenue              13%           12%            1ppt           12%          12%            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 March 31, 2022 Compared with Three Months Ended March 31, 2021

Research and development expenses increased $1.1 billion or 21% driven by investments in cloud engineering.

Nine Months Ended March 31, 2022 Compared with Nine Months Ended March 31, 2021

Research and development expenses increased $2.6 billion or 18% driven by investments in cloud engineering and Gaming.

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                                     PART I
                                     Item 2


Sales and Marketing

(In millions, except                Three Months Ended       Percentage          Nine Months Ended       Percentage
percentages)                                 March 31,           Change                  March 31,           Change


                                    2022          2021                           2022         2021

Sales and marketing           $    5,595      $  5,082              10%     $  15,521     $ 14,260               9%
As a percent of revenue              11%           12%           (1)ppt           11%          12%           (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 March 31, 2022 Compared with Three Months Ended March 31, 2021

Sales and marketing expenses increased $513 million or 10% driven by investments in commercial sales and LinkedIn. Sales and marketing included a favorable foreign currency impact of 3%.

Nine Months Ended March 31, 2022 Compared with Nine Months Ended March 31, 2021

Sales and marketing expenses increased $1.3 billion or 9% driven by investments in commercial sales, LinkedIn, and Windows marketing.

General and Administrative


(In millions, except               Three Months Ended      Percentage           Nine Months Ended      Percentage
percentages)                                March 31,          Change                   March 31,          Change


                                   2022          2021                           2022         2021

General and administrative   $    1,480      $  1,327             12%     $    4,151     $  3,585             16%
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 March 31, 2022 Compared with Three Months Ended March 31, 2021

General and administrative expenses increased $153 million or 12% driven by investments in corporate functions. General and administrative included a favorable foreign currency impact of 2%.

Nine Months Ended March 31, 2022 Compared with Nine Months Ended March 31, 2021

General and administrative expenses increased $566 million or 16% driven by investments in corporate functions.

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                                     Item 2


                          OTHER INCOME (EXPENSE), NET

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

                                                   Three Months Ended             Nine Months Ended
(In millions)                                               March 31,                     March 31,


                                               2022              2021           2022           2021

Interest and dividends income           $       519       $       519     $    1,542     $    1,634
Interest expense                               (503 )            (633 )       (1,567 )       (1,793 )
Net recognized gains (losses) on
investments                                     (76 )             353            595            837
Net losses on derivatives                       (29 )              (2 )          (29 )           (4 )
Net gains (losses) on foreign
currency remeasurements                         (74 )             (55 )         (152 )          126
Other, net                                      (11 )               6             (9 )           76


Total                                   $      (174 )     $       188     $      380     $      876


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 March 31, 2022 Compared with Three Months Ended March 31, 2021


Interest and dividends income was unchanged as lower portfolio balances were
offset by higher yields on interest rate securities. Interest expense decreased
due to a decrease in outstanding long-term debt due to debt maturities. Net
recognized losses on investments increased due to losses on equity securities in
the current period compared to gains in the prior period.

Nine Months Ended March 31, 2022 Compared with Nine Months Ended March 31, 2021


Interest and dividends income decreased due to lower portfolio balances.
Interest expense decreased due to a decrease in outstanding long-term debt due
to debt maturities. Net recognized gains on investments decreased due to lower
gains on equity securities.

                                  INCOME TAXES

Effective Tax Rate

Our effective tax rate was 17% and 10% for the three months ended March 31, 2022
and 2021, respectively, and 11% and 13% for the nine months ended March 31, 2022
and 2021, respectively. The increase in our effective tax rate for the three
months ended March 31, 2022 compared to the prior year was primarily due to tax
benefits from a decision by the India Supreme Court on withholding taxes in the
case of Engineering Analysis Centre of Excellence Private Limited vs The
Commissioner of Income Tax and an agreement between the U.S. and India tax
authorities related to transfer pricing in fiscal year 2021, a decrease in tax
benefits relating to stock-based compensation, and changes in the mix of our
income before income taxes between the U.S. and foreign countries. The decrease
in our effective tax rate for the nine months ended March 31, 2022 compared to
the prior year was primarily due to a $3.3 billion net income tax benefit in the
first quarter of fiscal year 2022 related to the transfer of intangible
properties, offset in part by tax benefits from the India Supreme Court decision
on withholding taxes and an agreement between the U.S. and India tax authorities
related to transfer pricing in fiscal year 2021, and changes in the mix of our
income before income taxes between the U.S. and foreign countries.

We have historically paid India withholding taxes on software sales through
distributor withholding and tax audit assessments in India. In March 2021, the
India Supreme Court ruled favorably for companies in 86 separate appeals, some
dating back to 2012, holding that software sales are not subject to India
withholding taxes. Although we were not a party to the appeals, our software
sales in India were determined to be not subject to withholding taxes.
Therefore, we recorded a net income tax benefit of $620 million in the third
quarter of fiscal year 2021 to reflect the results of the India Supreme Court
decision impacting fiscal year 1996 through fiscal year 2016.

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                                     PART I
                                     Item 2


In the first quarter of fiscal year 2022, we transferred certain intangible
properties from our Puerto Rico subsidiary to the U.S. The transfer of
intangible properties resulted in a $3.3 billion net income tax benefit in the
first quarter of fiscal year 2022, as the value of future U.S. tax deductions
exceeds the current tax liability from the U.S. global intangible low-taxed
income tax.

Our effective tax rate was lower than the U.S. federal statutory rate for the
three and nine months ended March 31, 2022, 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 center in
Ireland, tax benefits relating to stock-based compensation, and for the nine
months ended March 31, 2022, the net income tax benefit related to the transfer
of intangible properties.

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. In the second
quarter of fiscal year 2021, we settled an additional portion of the IRS 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 of March 31, 2022, 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 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 the U.S. Our
operations in certain jurisdictions remain subject to examination for tax years
1996 to 2021, 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 MEASURES

Adjusted net income and adjusted diluted EPS are non-GAAP financial measures
which exclude the net tax benefit related to the transfer of intangible
properties in the first quarter of fiscal year 2022 and the net income tax
benefit related to an India Supreme Court decision on withholding taxes in the
third quarter of fiscal year 2021. 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.

                                       44
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                                     PART I
                                     Item 2

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              Nine Months Ended       Percentage
amounts)                                                           March 31,           Change                      March 31,           Change


                                                       2022             2021                            2022            2021

Net income                                       $   16,728      $    15,457               8%     $   55,998      $   44,813              25%
Net income tax benefit related to transfer of
intangible properties                                     0                0                *         (3,291 )             0                *
Net income tax benefit related to India
Supreme Court decision on withholding taxes               0             (620 )              *              0            (620 )              *


Adjusted net income (non-GAAP)                   $   16,728      $    14,837              13%     $   52,707      $   44,193              19%


Diluted earnings per share                       $     2.22      $      2.03               9%     $     7.41      $     5.88              26%
Net income tax benefit related to transfer of
intangible properties                                     0                0                *          (0.43 )             0                *
Net income tax benefit related to India
Supreme Court decision on withholding taxes               0            (0.08 )              *              0           (0.08 )              *


Adjusted diluted earnings per share (non-GAAP)   $     2.22      $      1.95              14%     $     6.98      $     5.80              20%




* Not meaningful.


                              FINANCIAL CONDITION

Cash, Cash Equivalents, and Investments


Cash, cash equivalents, and short-term investments totaled $104.7 billion and
$130.3 billion as of March 31, 2022 and June 30, 2021, respectively. Equity
investments were $6.9 billion and $6.0 billion as of March 31, 2022 and June 30,
2021, 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 predominantly U.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
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.

                                       45
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                                     PART I
                                     Item 2


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 $10.4 billion to $64.4 billion for the nine
months ended March 31, 2022, 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 $8.5 billion to $45.6 billion for
the nine months ended March 31, 2022, mainly due to a $5.3 billion increase in
repayments of debt and a $3.7 billion increase in common stock repurchases. Cash
used in investing increased $3.9 billion to $20.6 billion for the nine months
ended March 31, 2022, mainly due to a $12.4 billion increase in cash used for
acquisitions of companies, net of cash acquired, and purchases of intangible and
other assets, and a $2.8 billion increase in additions to property and
equipment, offset in part by a $11.7 billion increase in cash from net
investment purchases, sales, and maturities.

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. In March 2021 and June 2020, we exchanged a portion of our
existing debt at a 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.

The following table outlines the expected future recognition of unearned revenue as of March 31, 2022:

(In millions)


Three Months Ending

June 30, 2022         $ 16,179
September 30, 2022       8,873
December 31, 2022        6,481
March 31, 2023           2,494
Thereafter               2,769


Total                 $ 36,796


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.

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                                     PART I
                                     Item 2


Share Repurchases

For the nine months ended March 31, 2022 and 2021, we repurchased 67 million
shares and 77 million shares of our common stock for $20.2 billion and $16.8
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


On January 18, 2022, we entered into a definitive agreement to acquire
Activision Blizzard, Inc. ("Activision Blizzard") for $95.00 per share in an
all-cash transaction valued at $68.7 billion, inclusive of Activision Blizzard's
net cash. We expect this acquisition to close in fiscal year 2023, subject to
approval by Activision Blizzard's shareholders, the satisfaction of certain
regulatory approvals, and other customary closing conditions.

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.

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 $6.2 billion, which
included $1.5 billion during the nine months ended March 31, 2022. The remaining
transition tax of $12.0 billion is payable over the next four 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 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.

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                                     PART I
                                     Item 2


                  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, legal and other
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 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 Investment Securities


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.

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                                     PART I
                                     Item 2


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.

                                       49
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                                     PART I
                                     Item 2


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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                                     PART I
                                   Item 3, 4

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