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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended December 31, 2018

OR

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Transition Period From            to

Commission File Number: 001-37845

 

MICROSOFT CORPORATION

(Exact name of registrant as specified in its charter)

 

 

Washington

 

91-1144442

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

 

 

One Microsoft Way, Redmond, Washington

 

98052-6399

(Address of principal executive offices)

 

(Zip Code)

(425) 882-8080

(Registrant’s telephone number, including area code)

None

(Former name, former address and former fiscal year, if changed since last report)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes  No 

Indicate by check mark whether the registrant has submitted electronically every Interactive Data File required to be submitted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit such files). Yes  No 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer 

 

Accelerated filer 

Non-accelerated filer 

 

Smaller reporting company 

Emerging growth company 

 

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act.

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes  No

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

 

Class

 

Outstanding as of January 25, 2019

 

 

 

 

 

Common Stock, $0.00000625 par value per share

 

 

7,672,213,446 shares

 

 

 

 

 

 


 

MICROSOFT CORPORATION

FORM 10-Q

For the Quarter Ended December 31, 2018

INDEX

 

 

 

Page

PART I.

FINANCIAL INFORMATION

 

 

 

 

 

 

Item 1.

Financial Statements

 

 

 

 

 

 

 

 

a)

Income Statements for the Three and Six Months Ended December 31, 2018 and 2017

3

 

 

 

 

 

 

 

b)

Comprehensive Income Statements for the Three and Six Months Ended December 31, 2018 and 2017

4

 

 

 

 

 

 

 

c)

Balance Sheets as of December 31, 2018 and June 30, 2018

5

 

 

 

 

 

 

 

d)

Cash Flows Statements for the Three and Six Months Ended December 31, 2018 and 2017

6

 

 

 

 

 

 

 

e)

Stockholders’ Equity Statements for the Three and Six Months Ended December 31, 2018 and 2017

7

 

 

 

 

 

 

 

f)

Notes to Financial Statements

8

 

 

 

 

 

 

 

g)

Report of Independent Registered Public Accounting Firm

32

 

 

 

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

33

 

 

 

 

 

 

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

47

 

 

 

 

 

 

Item 4.

Controls and Procedures

47

 

 

 

 

 

PART II. 

OTHER INFORMATION

 

 

 

 

 

 

 

Item 1.

Legal Proceedings

48

 

 

 

 

 

 

Item 1A.

Risk Factors

48

 

 

 

 

 

 

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

59

 

 

 

 

 

 

Item 6.

Exhibits

60

 

 

 

 

 

SIGNATURE

61

 

 

 

2


PART I

Item 1

 

PART I. FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

INCOME STATEMENTS

 

(In millions, except per share amounts) (Unaudited)

 

Three Months Ended
December 31,

 

 

Six Months Ended
December 31,

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2018

 

 

2017

 

 

 

2018

 

 

 

2017

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenue:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Product

 

$

  16,219

 

 

$

17,926

 

 

$

33,518

 

 

$

32,224

 

Service and other

 

 

16,252

 

 

 

10,992

 

 

 

28,037

 

 

 

21,232

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total revenue

 

 

32,471

 

 

 

28,918

 

 

 

61,555

 

 

 

53,456

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of revenue:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Product

 

 

5,885

 

 

 

5,498

 

 

 

9,534

 

 

 

8,478

 

Service and other

 

 

6,538

 

 

 

5,566

 

 

 

12,794

 

 

 

10,864

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total cost of revenue

 

 

12,423

 

 

 

11,064

 

 

 

22,328

 

 

 

19,342

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross margin

 

 

20,048

 

 

 

17,854

 

 

 

39,227

 

 

 

34,114

 

Research and development

 

 

4,070

 

 

 

3,504

 

 

 

8,047

 

 

 

7,078

 

Sales and marketing

 

 

4,588

 

 

 

4,562

 

 

 

8,686

 

 

 

8,374

 

General and administrative

 

 

1,132

 

 

 

1,109

 

 

 

2,281

 

 

 

2,275

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating income

 

 

10,258

 

 

 

8,679

 

 

 

20,213

 

 

 

16,387

 

Other income, net

 

 

127

 

 

 

490

 

 

 

393

 

 

 

766

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income before income taxes

 

 

10,385

 

 

 

9,169

 

 

 

20,606

 

 

 

17,153

 

Provision for income taxes

 

 

1,965

 

 

 

15,471

 

 

 

3,362

 

 

 

16,879

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

8,420

 

 

$

(6,302

)

 

$

17,244

 

 

$

274

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings (loss) per share:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

1.09

 

 

$

(0.82

)

 

$

2.24

 

 

$

0.04

 

Diluted

 

$

1.08

 

 

$

(0.82

)

 

$

2.22

 

 

$

0.04

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average shares outstanding:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

 

7,692

 

 

 

7,710

 

 

 

7,683

 

 

 

7,709

 

Diluted

 

 

7,768

 

 

 

7,710

 

 

 

7,767

 

 

 

7,799

 

 

 

 

 

 

 

 

 

 

 

 

Refer to accompanying notes.

 

 

3


PART I

Item 1

 

COMPREHENSIVE INCOME STATEMENTS

 

(In millions) (Unaudited)

 

Three Months Ended
December 31,

 

 

Six Months Ended
December 31,

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2018

 

 

2017

 

 

2018

 

 

2017

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

  8,420

 

 

$

  (6,302

)

 

$

  17,244

 

 

$

274

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income (loss), net of tax:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net change related to derivatives

 

 

(15

)

 

 

(7

)

 

 

(60

)

 

 

(113

)

Net change related to investments

 

 

881

 

 

 

(878

)

 

 

620

 

 

 

(1,166

)

Translation adjustments and other

 

 

(264

)

 

 

(40

)

 

 

(319

)

 

 

253

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income (loss)

 

 

602

 

 

 

(925

)

 

 

241

 

 

 

(1,026

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Comprehensive income (loss)

 

$

  9,022

 

 

$

  (7,227

)

 

$

  17,485

 

 

$

(752

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Refer to accompanying notes. Refer to Note 16 – Accumulated Other Comprehensive Income (Loss) for further information.

 

 

4


PART I

Item 1

 

BALANCE SHEETS

 

(In millions) (Unaudited)

 

 

 

 

 

 

 

 

 

 

December 31,
2018

 

 

June 30,
2018

 

 

 

 

Assets

 

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

6,638

 

 

$

11,946

 

Short-term investments

 

 

121,024

 

 

 

121,822

 

 

 

 

 

 

 

 

 

 

 

 

 

Total cash, cash equivalents, and short-term investments

 

 

127,662

 

 

 

133,768

 

Accounts receivable, net of allowance for doubtful accounts of $354 and $377

 

 

19,680

 

 

 

26,481

 

Inventories

 

 

1,961

 

 

 

2,662

 

Other

 

 

7,571

 

 

 

6,751

 

 

 

 

 

 

 

 

 

 

 

 

 

Total current assets

 

 

156,874

 

 

 

169,662

 

Property and equipment, net of accumulated depreciation of $33,082 and $29,223

 

 

32,717

 

 

 

29,460

 

Operating lease right-of-use assets

 

 

6,806

 

 

 

6,686

 

Equity investments

 

 

2,274

 

 

 

1,862

 

Goodwill

 

 

41,577

 

 

 

35,683

 

Intangible assets, net

 

 

8,482

 

 

 

8,053

 

Other long-term assets

 

 

10,129

 

 

 

7,442

 

 

 

 

 

 

 

 

 

 

 

 

 

Total assets

 

$

258,859

 

 

$

258,848

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Liabilities and stockholders’ equity

 

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

 

Accounts payable

 

$

7,563

 

 

$

8,617

 

Current portion of long-term debt

 

 

3,516

 

 

 

3,998

 

Accrued compensation

 

 

4,624

 

 

 

6,103

 

Short-term income taxes

 

 

2,033

 

 

 

2,121

 

Short-term unearned revenue

 

 

24,285

 

 

 

28,905

 

Other

 

 

8,297

 

 

 

8,744

 

 

 

 

 

 

 

 

 

 

 

 

 

Total current liabilities

 

 

50,318

 

 

 

58,488

 

Long-term debt

 

 

69,653

 

 

 

72,242

 

Long-term income taxes

 

 

29,161

 

 

 

30,265

 

Long-term unearned revenue

 

 

3,799

 

 

 

3,815

 

Deferred income taxes

 

 

2,062

 

 

 

541

 

Operating lease liabilities

 

 

5,683

 

 

 

5,568

 

Other long-term liabilities

 

 

6,055

 

 

 

5,211

 

 

 

 

 

 

 

 

 

 

 

 

 

Total liabilities

 

 

166,731

 

 

 

176,130

 

 

 

 

 

 

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

 

 

 

Common stock and paid-in capital – shares authorized 24,000; outstanding 7,683 and 7,677

 

 

77,556

 

 

 

71,223

 

Retained earnings

 

 

16,585

 

 

 

13,682

 

Accumulated other comprehensive loss

 

 

(2,013

)

 

 

(2,187

)

 

 

 

 

 

 

 

 

 

 

 

 

Total stockholders’ equity

 

 

92,128

 

 

 

82,718

 

 

 

 

 

 

 

 

 

 

 

 

 

Total liabilities and stockholders’ equity

 

$

258,859

 

 

$

258,848

 

 

 

 

 

 

 

 

 

 

 

Refer to accompanying notes.

 

5


PART I

Item 1

 

CASH FLOWS STATEMENTS

 

(In millions) (Unaudited)

 

Three Months Ended

December 31,

 

 

Six Months Ended

December 31,

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2018

 

 

2017

 

 

2018

 

 

2017

 

 

 

 

 

 

 

 

 

 

 

 

 

Operations

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

8,420

 

 

$

(6,302

)

 

$

17,244

 

 

$

274

 

 

Adjustments to reconcile net income (loss) to net cash from operations:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Depreciation, amortization, and other

 

 

2,995

 

 

 

2,536

 

 

 

5,832

 

 

 

5,035

 

Stock-based compensation expense

 

 

1,183

 

 

 

986

 

 

 

2,290

 

 

 

1,959

 

Net recognized gains on investments and derivatives

 

 

(135

)

 

 

(684

)

 

 

(375

)

 

 

(1,207

)

Deferred income taxes

 

 

(173

)

 

 

(2,305

)

 

 

(420

)

 

 

(2,358

)

Changes in operating assets and liabilities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Accounts receivable

 

 

(2,396

)

 

 

(3,908

)

 

 

6,798

 

 

 

4,041

 

Inventories

 

 

1,654

 

 

 

1,205

 

 

 

698

 

 

 

182

 

Other current assets

 

 

(173

)

 

 

354

 

 

 

(850

)

 

 

36

 

Other long-term assets

 

 

(473

)

 

 

(344

)

 

 

(452

)

 

 

(622

)

Accounts payable

 

 

(440

)

 

 

938

 

 

 

(835

)

 

 

531

 

Unearned revenue

 

 

(2,122

)

 

 

(1,065

)

 

 

(4,563

)

 

 

(2,871

)

Income taxes

 

 

(64

)

 

 

15,974

 

 

 

(1,155

)

 

 

16,635

 

Other current liabilities

 

 

656

 

 

 

643

 

 

 

(1,666

)

 

 

(1,521

)

Other long-term liabilities

 

 

(32

)

 

 

(153

)

 

 

11

 

 

 

201

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net cash from operations

 

 

8,900

 

 

 

7,875

 

 

 

22,557

 

 

 

20,315

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Financing

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Proceeds from issuance of short-term debt, maturities of 90 days or less, net

 

 

0

 

 

 

3,759

 

 

 

0

 

 

 

49

 

Proceeds from issuance of debt

 

 

0

 

 

 

3,229

 

 

 

0

 

 

 

7,183

 

Repayments of debt

 

 

(3,000

)

 

 

(3,327

)

 

 

(3,000

)

 

 

(4,496

)

Common stock issued

 

 

200

 

 

 

189

 

 

 

560

 

 

 

496

 

Common stock repurchased

 

 

(6,413

)

 

 

(2,008

)

 

 

(10,157

)

 

 

(4,578

)

Common stock cash dividends paid

 

 

(3,544

)

 

 

(3,238

)

 

 

(6,764

)

 

 

(6,241

)

Other, net

 

 

(459

)

 

 

(156

)

 

 

(1,239

)

 

 

(306

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net cash used in financing

 

 

(13,216

)

 

 

(1,552

)

 

 

(20,600

)

 

 

(7,893

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Investing

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Additions to property and equipment

 

 

(3,707

)

 

 

(2,586

)

 

 

(7,309

)

 

 

(4,718

)

Acquisition of companies, net of cash acquired, and purchases of intangible and other assets

 

 

(1,593

)

 

 

(27

)

 

 

(1,838

)

 

 

(206

)

Purchases of investments

 

 

(16,858

)

 

 

(45,154

)

 

 

(36,409

)

 

 

(78,115

)

Maturities of investments

 

 

3,782

 

 

 

6,352

 

 

 

8,996

 

 

 

11,578

 

Sales of investments

 

 

14,176

 

 

 

41,261

 

 

 

29,407

 

 

 

64,297

 

Securities lending payable

 

 

0

 

 

 

(177

)

 

 

0

 

 

 

(71

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net cash used in investing

 

 

(4,200

)

 

 

(331

)

 

 

(7,153

)

 

 

(7,235

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Effect of foreign exchange rates on cash and cash equivalents

 

 

17

 

 

 

(17

)

 

 

(112

)

 

 

9

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net change in cash and cash equivalents

 

 

(8,499

)

 

 

5,975

 

 

 

(5,308

)

 

 

5,196

 

Cash and cash equivalents, beginning of period

 

 

15,137

 

 

 

6,884

 

 

 

11,946

 

 

 

7,663

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents, end of period

 

$

6,638

 

 

$

12,859

 

 

$

6,638

 

 

$

12,859

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Refer to accompanying notes.

 

6


PART I

Item 1

 

STOCKHOLDERS’ EQUITY STATEMENTS

 

(In millions) (Unaudited)

 

Three Months Ended

December 31,

 

 

Six Months Ended

December 31,

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2018

 

 

2017

 

 

 

2018

 

 

 

2017

 

 

 

 

 

 

 

 

 

 

 

 

 

Common stock and paid-in capital

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, beginning of period

 

$

71,303

 

 

$

69,419

 

 

$

71,223

 

 

$

69,315

 

Common stock issued

 

 

5,887

 

 

 

189

 

 

 

6,247

 

 

 

496

 

Common stock repurchased

 

 

(828

)

 

 

(402

)

 

 

(2,215

)

 

 

(1,577

)

Stock-based compensation expense

 

 

1,183

 

 

 

986

 

 

 

2,290

 

 

 

1,959

 

Other, net

 

 

11

 

 

 

0

 

 

 

11

 

 

 

(1

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, end of period

 

 

77,556

 

 

 

70,192

 

 

 

77,556

 

 

 

70,192

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Retained earnings

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, beginning of period

 

 

17,279

 

 

 

19,702

 

 

 

13,682

 

 

 

17,769

 

Net income (loss)

 

 

8,420

 

 

 

(6,302

)

 

 

17,244

 

 

 

274

 

Common stock cash dividends

 

 

(3,546

)

 

 

(3,232

)

 

 

(7,074

)

 

 

(6,471

)

Common stock repurchased

 

 

(5,568

)

 

 

(1,601

)

 

 

(7,944

)

 

 

(3,005

)

Cumulative effect of accounting changes

 

 

0

 

 

 

0

 

 

 

677

 

 

 

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, end of period

 

 

16,585

 

 

 

8,567

 

 

 

16,585

 

 

 

8,567

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Accumulated other comprehensive income (loss)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, beginning of period

 

 

(2,615

)

 

 

526

 

 

 

(2,187

)

 

 

627

 

Other comprehensive income (loss)

 

 

602

 

 

 

(925

)

 

 

241

 

 

 

(1,026

)

Cumulative effect of accounting changes

 

 

0

 

 

 

0

 

 

 

(67

)

 

 

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, end of period

 

 

(2,013

)

 

 

(399

)

 

 

(2,013

)

 

 

(399

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total stockholders’ equity

 

$

92,128

 

 

$

78,360

 

 

$

92,128

 

 

$

78,360

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash dividends declared per common share

 

$

0.46

 

 

$

0.42

 

 

$

0.92

 

 

$

0.84

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Refer to accompanying notes.

 

 

7


PART I

Item 1

 

NOTES TO FINANCIAL STATEMENTS

(Unaudited)

 

NOTE 1 — ACCOUNTING POLICIES

Accounting Principles

Our unaudited interim consolidated financial statements and accompanying notes are prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). In the opinion of management, the unaudited interim consolidated financial statements reflect all adjustments of a normal recurring nature that are necessary for a fair presentation of the results for the interim periods presented. Interim results are not necessarily indicative of results for a full year. The information included in this Form 10-Q should be read in conjunction with information included in the Microsoft Corporation fiscal year 2018 Form 10-K filed with the U.S. Securities and Exchange Commission (“SEC”) on August 3, 2018.

We have recast certain prior period amounts related to investments, derivatives, and fair value measurements to conform to the current period presentation based on our adoption of the new accounting standard for financial instruments. We have also recast prior period commercial cloud revenue to include the commercial portion of LinkedIn to provide a comparable view of our commercial cloud business performance. The commercial portion of LinkedIn includes LinkedIn Recruiter, Sales Navigator, premium business subscriptions, and other services for organizations. The recast of these prior period amounts had no impact on our consolidated financial statements.

Principles of Consolidation

The consolidated financial statements include the accounts of Microsoft Corporation and its subsidiaries. Intercompany transactions and balances have been eliminated.

Estimates and Assumptions

Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. Examples of estimates and assumptions include: for revenue recognition, determining the nature and timing of satisfaction of performance obligations, and determining the standalone selling price of performance obligations, variable consideration, and other obligations such as product returns and refunds; loss contingencies; product warranties; the fair value of and/or potential impairment of goodwill and intangible assets for our reporting units; product life cycles; useful lives of our tangible and intangible assets; allowances for doubtful accounts; the market value of, and demand for, our inventory; stock-based compensation forfeiture rates; when technological feasibility is achieved for our products; the potential outcome of future tax consequences of events that have been recognized on our consolidated financial statements or tax returns; and determining the timing and amount of impairments for investments. Actual results and outcomes may differ from management’s estimates and assumptions.

Financial Instruments

Investments

We consider all highly liquid interest-earning investments with a maturity of three months or less at the date of purchase to be cash equivalents. The fair values of these investments approximate their carrying values. In general, investments with original maturities of greater than three months and remaining maturities of less than one year are classified as short-term investments. Investments with maturities beyond one year may be classified as short-term based on their highly liquid nature and because such marketable securities represent the investment of cash that is available for current operations.

8


PART I

Item 1

 

Debt investments are classified as available-for-sale and realized gains and losses are recorded using the specific identification method. Changes in fair value, excluding other-than-temporary impairments, are recorded in other comprehensive income (“OCI”). Debt investments are impaired when a decline in fair value is judged to be other-than-temporary. Fair value is calculated based on publicly available market information or other estimates determined by management. We employ a systematic methodology on a quarterly basis 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.

Equity investments with readily determinable fair values are measured at fair value. Equity investments without readily determinable fair values are measured using the equity method, or measured at cost with adjustments for observable changes in price or impairments (referred to as the measurement alternative). We perform a qualitative assessment on a quarterly basis and recognize an impairment if there are sufficient indicators that the fair value of the investment is less than carrying value. Changes in value are recorded in other income (expense), net.

We lend certain fixed-income and equity securities to increase investment returns. These transactions are accounted for as secured borrowings and the loaned securities continue to be carried as investments on our consolidated balance sheets. Cash and/or security interests are received as collateral for the loaned securities with the amount determined based upon the underlying security lent and the creditworthiness of the borrower. Cash received is recorded as an asset with a corresponding liability.

Derivatives

Derivative instruments are recognized as either assets or liabilities and measured at fair value. The accounting for changes in the fair value of a derivative depends on the intended use of the derivative and the resulting designation.

For derivative instruments designated as fair value hedges, gains and losses are recognized in other income (expense), net with offsetting gains and losses on the hedged items. For options designated as fair value hedges, changes in the time value are excluded from the assessment of hedge effectiveness and recognized in other income (expense), net.

For derivative instruments designated as cash flow hedges, the effective portion of the gains and losses are initially reported as a component of OCI and subsequently recognized in revenue when the hedged exposure is recognized in revenue. Gains and losses on derivatives representing either hedge components excluded from the assessment of effectiveness or hedge ineffectiveness are recognized in other income (expense), net.

For derivative instruments that are not designated as hedges, gains and losses from changes in fair values are primarily recognized in other income (expense), net.

Fair Value Measurements

We account for certain assets and liabilities at fair value. The hierarchy below lists three levels of fair value based on the extent to which inputs used in measuring fair value are observable in the market. We categorize each of our fair value measurements in one of these three levels based on the lowest level input that is significant to the fair value measurement in its entirety. These levels are:

 

Level 1 – inputs are based upon unadjusted quoted prices for identical instruments in active markets. Our Level 1 investments include U.S. government securities, common and preferred stock, and mutual funds. Our Level 1 derivative assets and liabilities include those actively traded on exchanges.

9


PART I

Item 1

 

 

Level 2 – inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, and model-based valuation techniques (e.g. the Black-Scholes model) for which all significant inputs are observable in the market or can be corroborated by observable market data for substantially the full term of the assets or liabilities. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs including interest rate curves, credit spreads, foreign exchange rates, and forward and spot prices for currencies. Our Level 2 investments include commercial paper, certificates of deposit, U.S. agency securities, foreign government bonds, mortgage- and asset-backed securities, corporate notes and bonds, and municipal securities. Our Level 2 derivative assets and liabilities primarily include certain over-the-counter option and swap contracts.

 

Level 3 – inputs are generally unobservable and typically reflect management’s estimates of assumptions that market participants would use in pricing the asset or liability. The fair values are therefore determined using model-based techniques, including option pricing models and discounted cash flow models. Our Level 3 assets and liabilities include investments in corporate notes and bonds, and goodwill and intangible assets, when they are recorded at fair value due to an impairment charge. Unobservable inputs used in the models are significant to the fair values of the assets and liabilities.

We measure equity investments without readily determinable fair values on a nonrecurring basis. The fair values of these investments are determined based on valuation techniques using the best information available, and may include quoted market prices, market comparables, and discounted cash flow projections.  

Our other current financial assets and current financial liabilities have fair values that approximate their carrying values.

Contract Balances  

As of December 31, 2018 and June 30, 2018, long-term accounts receivable, net of allowance for doubtful accounts, were $1.9 billion and $1.8 billion, respectively, and are included in other long-term assets on our consolidated balance sheets.

Recent Accounting Guidance

Recently Adopted Accounting Guidance

Income Taxes – Intra-Entity Asset Transfers

In October 2016, the Financial Accounting Standards Board (“FASB”) issued new guidance requiring an entity to recognize the income tax consequences of an intra-entity transfer of an asset other than inventory when the transfer occurs, rather than when the asset has been sold to an outside party. We adopted the guidance effective July 1, 2018. Adoption of the guidance was applied using a modified retrospective approach through a cumulative-effect adjustment to retained earnings as of the effective date. We recorded a net cumulative-effect adjustment that resulted in an increase in retained earnings of $557 million, which reversed the previous deferral of income tax consequences and recorded new deferred tax assets from intra-entity transfers involving assets other than inventory, partially offset by a U.S. deferred tax liability related to global intangible low-taxed income (“GILTI”). Adoption of the standard resulted in an increase in long-term deferred tax assets of $2.8 billion, an increase in long-term deferred tax liabilities of $2.1 billion, and a reduction in other current assets of $152 million. As a result of the Tax Cuts and Jobs Act (“TCJA”), we are continuing to evaluate the impact of this standard on our consolidated financial statements, including accounting policies, processes, and systems. Adoption of the standard had no impact to cash from or used in operating, financing, or investing on our consolidated cash flows statements.

Financial Instruments – Recognition, Measurement, Presentation, and Disclosure

In January 2016, the FASB issued a new standard related to certain aspects of recognition, measurement, presentation, and disclosure of financial instruments. Most prominent among the changes in the standard is the requirement for changes in the fair value of our equity investments, with certain exceptions, to be recognized through net income rather than OCI.

10


PART I

Item 1

 

We adopted the standard effective July 1, 2018. Adoption of the standard was applied using a modified retrospective approach through a cumulative-effect adjustment from accumulated other comprehensive income (“AOCI”) to retained earnings as of the effective date, and we elected to measure equity investments without readily determinable fair values at cost with adjustments for observable changes in price or impairments. The cumulative-effect adjustment included any previously held unrealized gains and losses held in AOCI related to our equity investments carried at fair value as well as the impact of recording the fair value of certain equity investments carried at cost. The impact on our consolidated balance sheets upon adoption was not material. Adoption of the standard had no impact to cash from or used in operating, financing, or investing on our consolidated cash flows statements.

Recent Accounting Guidance Not Yet Adopted

Financial Instruments – Targeted Improvements to Accounting for Hedging Activities

In August 2017, the FASB issued new guidance related to accounting for hedging activities. This guidance expands strategies that qualify for hedge accounting, changes how many hedging relationships are presented in the financial statements, and simplifies the application of hedge accounting in certain situations. The standard will be effective for us beginning July 1, 2019, with early adoption permitted for any interim or annual period before the effective date. Adoption of the standard will be applied using a modified retrospective approach through a cumulative-effect adjustment to retained earnings as of the effective date. We are currently evaluating the impact of this standard on our consolidated financial statements, including accounting policies, processes, and systems.

Financial Instruments – Credit Losses

In June 2016, the FASB issued a new standard to replace the incurred loss impairment methodology under current GAAP with a methodology that reflects expected credit losses and requires consideration of a broader range of reasonable and supportable information to inform credit loss estimates. We will be required to use a forward-looking expected credit loss model for accounts receivables, loans, and other financial instruments. Credit losses relating to available-for-sale debt securities will also be recorded through an allowance for credit losses rather than as a reduction in the amortized cost basis of the securities. The standard will be effective for us beginning July 1, 2020, with early adoption permitted beginning July 1, 2019. Adoption of the standard will be applied using a modified retrospective approach through a cumulative-effect adjustment to retained earnings as of the effective date to align our credit loss methodology with the new standard. We are currently evaluating the impact of this standard on our consolidated financial statements, including accounting policies, processes, and systems.

 

NOTE 2 EARNINGS PER SHARE

Basic earnings per share (“EPS”) is computed based on the weighted average number of shares of common stock outstanding during the period. Diluted EPS is computed based on the weighted average number of shares of common stock plus the effect of dilutive potential common shares outstanding during the period using the treasury stock method. Dilutive potential common shares include outstanding stock options and stock awards.

The components of basic and diluted EPS were as follows:

 

(In millions, except per share amounts)

 

Three Months Ended

December 31,

 

 

Six Months Ended

December 31,

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2018

 

 

2017

 

 

2018

 

 

2017

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) available for common shareholders (A)

 

$

8,420

 

 

$

(6,302

)

 

$

17,244

 

 

$

274

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted average outstanding shares of common stock (B)

 

 

7,692

 

 

 

7,710

 

 

 

7,683

 

 

 

7,709

 

Dilutive effect of stock-based awards

 

 

76

 

 

 

0

 

 

 

84

 

 

 

90

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Common stock and common stock equivalents (C)

 

 

7,768

 

 

 

7,710

 

 

 

7,767

 

 

 

7,799

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Earnings (Loss) Per Share

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic (A/B)

 

$

1.09

 

 

$

(0.82

)

 

$

2.24

 

 

$

0.04

 

Diluted (A/C)

 

$

1.08

 

 

$

(0.82

)

 

$

2.22

 

 

$

0.04

 

 

 

 

 

 

 

 

 

 

 

 

Anti-dilutive stock-based awards excluded from the calculations of diluted EPS were immaterial during the periods presented. In periods where we recognized a net loss, we excluded the impact of potentially dilutive outstanding stock-based awards from the calculation of diluted loss per share as their inclusion would have an antidilutive effect.

11


PART I

Item 1

 

 

NOTE 3 — OTHER INCOME (EXPENSE), NET

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

 

(In millions)

 

Three Months Ended

December 31,

 

 

Six Months Ended

December 31,

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2018

 

 

2017

 

 

2018

 

 

2017

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest and dividends income

 

$

704

 

 

$

530

 

 

$

1,385

 

 

$

1,003

 

Interest expense

 

 

  (672

)

 

 

  (698

)

 

 

(1,346

)

 

 

(1,370

)

Net recognized gains on investments

 

 

94

 

 

 

768

 

 

 

337

 

 

 

1,341

 

Net gains (losses) on derivatives

 

 

41

 

 

 

(84

)

 

 

38

 

 

 

(134

)

Net losses on foreign currency remeasurements

 

 

(74

)

 

 

(60

)

 

 

(69

)

 

 

(69

)

Other, net

 

 

34

 

 

 

34

 

 

 

48

 

 

 

(5

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

127

 

 

$

490

 

 

$

393

 

 

$

766

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net Recognized Gains (Losses) on Investments

Net recognized gains (losses) on debt investments were as follows:

 

(In millions)

 

Three Months Ended

December 31,

 

 

Six Months Ended

December 31,

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2018

 

 

2017

 

 

 

2018

 

 

 

2017

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Realized gains from sales of available-for-sale securities

 

$

6

 

 

$

5

 

 

$

13

 

 

$

18

 

Realized losses from sales of available-for-sale securities

 

 

(5

)

 

 

(259

)

 

 

(90

)

 

 

(339

)

Other-than-temporary impairments of investments

 

 

(7

)

 

 

(4

)

 

 

(7

)

 

 

(5

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

(6

)

 

$

(258

)

 

$

(84

)

 

$

(326

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net recognized gains (losses) on equity investments were as follows:

 

(In millions)

 

Three Months Ended

December 31,

 

 

Six Months Ended

December 31,

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2018

 

 

2017

 

 

 

2018

 

 

 

2017

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net realized gains on investments sold

 

$

30

 

 

$

1,046

 

 

$

233

 

 

$

1,692

 

Net unrealized gains on investments still held

 

 

73

 

 

 

0

 

 

 

191

 

 

 

0

 

Impairments of investments

 

 

(3

)

 

 

(20

)

 

 

(3

)

 

 

(25

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

100

 

 

$

1,026

 

 

$

421

 

 

$

1,667

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

12


PART I

Item 1

 

NOTE 4  INVESTMENTS

Investment Components

The components of investments were as follows:

 

(In millions)

 

Fair Value Level

 

Cost Basis

 

Unrealized

Gains

 

Unrealized

Losses

 

Recorded Basis

 

Cash and Cash

Equivalents

 

Short-term

Investments

 

Equity

Investments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2018

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Changes in Fair Value Recorded in

Other Comprehensive Income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial paper

 

Level 2

 

$

1,306

 

$

0

 

$

0

 

$

1,306

 

$

1,207

 

$

99

 

$

0

 

Certificates of deposit

 

Level 2

 

 

1,440

 

 

0

 

 

0

 

 

1,440

 

 

1,024

 

 

416

 

 

0

 

U.S. government securities

 

Level 1

 

 

103,915

 

 

422

 

 

(707

)

 

103,630

 

 

3

 

 

103,627

 

 

0

 

U.S. agency securities

 

Level 2

 

 

290

 

 

0

 

 

0

 

 

290

 

 

0

 

 

290

 

 

0

 

Foreign government bonds

 

Level 2

 

 

6,412

 

 

1

 

 

(11

)

 

6,402

 

 

1,029

 

 

5,373

 

 

0

 

Mortgage- and asset-backed securities

 

Level 2

 

 

3,540

 

 

3

 

 

(15

)

 

3,528

 

 

0

 

 

3,528

 

 

0

 

Corporate notes and bonds

 

Level 2

 

 

7,445

 

 

14

 

 

(79

)

 

7,380

 

 

15

 

 

7,365

 

 

0

 

Corporate notes and bonds

 

Level 3

 

 

15

 

 

0

 

 

0

 

 

15

 

 

0

 

 

15

 

 

0

 

Municipal securities

 

Level 2

 

 

268

 

 

35

 

 

(1

)

 

302

 

 

0

 

 

302

 

 

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total debt investments

 

 

 

$

124,631

 

$

475

 

$

(813

)

$

124,293

 

$

3,278

 

$

121,015

 

$

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Changes in Fair Value Recorded in

Net Income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Equity investments

 

Level 1

 

 

 

 

 

 

 

 

 

 

$

584

 

$

321

 

$

20

 

$

243

 

Equity investments

 

Other

 

 

 

 

 

 

 

 

 

 

 

2,031

 

 

0

 

 

0

 

 

2,031

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total equity investments

 

 

 

 

 

 

 

 

 

 

 

 

$

2,615

 

$

321

 

$

20

 

$

2,274

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

��

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash

 

 

 

 

 

 

 

 

 

 

 

 

$

3,039

 

$

3,039

 

$

0

 

$

0

 

Derivatives, net (a)

 

 

 

 

 

 

 

 

 

 

 

 

 

(11

)

 

0

 

 

(11

)

 

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

$

129,936

 

$

6,638

 

$

121,024

 

$

2,274

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

13


PART I

Item 1

 

(In millions)

 

Fair Value Level

 

Cost Basis

 

Unrealized

Gains

 

Unrealized

Losses

 

Recorded Basis

 

Cash and Cash

Equivalents

 

Short-term

Investments

 

Equity

Investments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

June 30, 2018

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Changes in Fair Value Recorded in

Other Comprehensive Income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Commercial paper

 

Level 2

 

$

2,513

 

$

0

 

$

0

 

$

2,513

 

$

2,215

 

$

298

 

$

0

 

Certificates of deposit

 

Level 2

 

 

2,058

 

 

0

 

 

0

 

 

2,058

 

 

1,865

 

 

193

 

 

0

 

U.S. government securities

 

Level 1

 

 

108,120

 

 

62

 

 

(1,167

)

 

107,015

 

 

2,280

 

 

104,735

 

 

0

 

U.S. agency securities

 

Level 2

 

 

1,742

 

 

0

 

 

0

 

 

1,742

 

 

1,398

 

 

344

 

 

0

 

Foreign government bonds

 

Level 1

 

 

22

 

 

0

 

 

0

 

 

22

 

 

0

 

 

22

 

 

0

 

Foreign government bonds

 

Level 2

 

 

5,063

 

 

1

 

 

(10

)

 

5,054

 

 

0

 

 

5,054

 

 

0

 

Mortgage- and asset-backed securities

 

Level 2

 

 

3,864

 

 

4

 

 

(13

)

 

3,855

 

 

0

 

 

3,855

 

 

0

 

Corporate notes and bonds

 

Level 2

 

 

6,929

 

 

21

 

 

(56

)

 

6,894

 

 

0

 

 

6,894

 

 

0

 

Corporate notes and bonds

 

Level 3

 

 

15

 

 

0

 

 

0

 

 

15

 

 

0

 

 

15

 

 

0

 

Municipal securities

 

Level 2

 

 

271

 

 

37

 

 

(1

)

 

307

 

 

0

 

 

307

 

 

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total debt investments

 

 

 

$

130,597

 

$

125

 

$

(1,247

)

$

129,475

 

$

7,758

 

$

121,717

 

$

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Equity investments

 

Level 1

 

 

 

 

 

 

 

 

 

 

$

533

 

$

246

 

$

0

 

$

287

 

Equity investments

 

Level 3

 

 

 

 

 

 

 

 

 

 

 

18

 

 

0

 

 

0

 

 

18

 

Equity investments

 

Other

 

 

 

 

 

 

 

 

 

 

 

1,558

 

 

0

 

 

1

 

 

1,557

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total equity investments

 

 

 

 

 

 

 

 

 

 

 

 

$

2,109

 

$

246

 

$

1

 

$

1,862

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash

 

 

 

 

 

 

 

 

 

 

 

 

$

3,942

 

$

3,942

 

$

0

 

$

0

 

Derivatives, net (a)

 

 

 

 

 

 

 

 

 

 

 

 

 

104

 

 

0

 

 

104

 

 

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

$

135,630

 

$

11,946

 

$

121,822

 

$

1,862

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(a)

Refer to Note 5 – Derivatives for further information on the fair value of our derivative instruments.

Equity investments presented as “Other” in the tables above include investments without readily determinable fair values measured using the equity method or measured at cost with adjustments for observable changes in price or impairments, and investments measured at fair value using net asset value as a practical expedient which are not categorized in the fair value hierarchy. As of December 31, 2018 and June 30, 2018, equity investments without readily determinable fair values measured at cost with adjustments for observable changes in price or impairments were $1.1 billion and $697 million, respectively.

As of December 31, 2018, we had no collateral received under agreements for loaned securities. As of June 30, 2018, collateral received under agreements for loaned securities was $1.8 billion and primarily comprised U.S. government and agency securities.

Unrealized Losses on Debt Investments

Debt investments with continuous unrealized losses for less than 12 months and 12 months or greater and their related fair values were as follows:

 

 

 

Less than 12 Months

 

 

12 Months or Greater

 

 

 

 

 

 

 

Total
Unrealized
Losses

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(In millions)

 

 

Fair Value

 

 

 

Unrealized
Losses

 

 

 

Fair Value

 

 

 

Unrealized
Losses

 

 

 

Total
Fair Value

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2018

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. government and agency securities

 

$

16,776

 

 

$

(93

)

 

$

52,757

 

 

$

(614

)

 

$

69,533

 

 

$

(707

)

Foreign government bonds

 

 

51

 

 

 

(4

)

 

 

87

 

 

 

(7

)

 

 

138

 

 

 

(11

)

Mortgage- and asset-backed securities

 

 

1,825

 

 

 

(8

)

 

 

359

 

 

 

(7

)

 

 

2,184

 

 

 

(15

)

Corporate notes and bonds

 

 

4,372

 

 

 

(53

)

 

 

770

 

 

 

(26

)

 

 

5,142

 

 

 

(79

)

Municipal securities

 

 

29

 

 

 

(1

)

 

 

13

 

 

 

0

 

 

 

42

 

 

 

(1

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

23,053

 

 

$

  (159

)

 

$

  53,986

 

 

$

  (654

)

 

$

 77,039

 

 

$

  (813

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

14


PART I

Item 1

 

 

 

Less than 12 Months

 

 

12 Months or Greater

 

 

 

 

 

 

 

Total
Unrealized
Losses

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(In millions)

 

 

Fair Value

 

 

 

Unrealized
Losses

 

 

 

Fair Value

 

 

 

Unrealized
Losses

 

 

 

Total
Fair Value

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

June 30, 2018

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

U.S. government and agency securities

 

$

82,352

 

 

$

(1,064

)

 

$

4,459

 

 

$

(103

)

 

$

86,811

 

 

$

(1,167

)

Foreign government bonds

 

 

3,457

 

 

 

(7

)

 

 

13

 

 

 

(3

)

 

 

3,470

 

 

 

(10

)

Mortgage- and asset-backed securities

 

 

2,072

 

 

 

(9

)

 

 

96

 

 

 

(4

)

 

 

2,168

 

 

 

(13

)

Corporate notes and bonds

 

 

3,111

 

 

 

(43

)

 

 

301

 

 

 

(13

)

 

 

3,412

 

 

 

(56

)

Municipal securities

 

 

45

 

 

 

(1

)

 

 

0

 

 

 

0

 

 

 

45

 

 

 

(1

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

91,037

 

 

$

  (1,124

)

 

$

  4,869

 

 

$

  (123

)

 

$

 95,906

 

 

$

  (1,247

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Unrealized losses from fixed-income securities are primarily attributable to changes in interest rates. Management does not believe any remaining unrealized losses represent other-than-temporary impairments based on our evaluation of available evidence.

Debt Investment Maturities

 

(In millions)

 

Cost Basis

 

 

Estimated

Fair Value

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2018

 

 

 

 

 

 

 

 

 

 

 

Due in one year or less

 

$

39,245

 

 

$

39,040

 

Due after one year through five years

 

 

58,499

 

 

 

58,306

 

Due after five years through 10 years

 

 

26,009

 

 

 

26,077

 

Due after 10 years

 

 

878

 

 

 

870

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

  124,631

 

 

$

  124,293

 

 

 

 

 

 

 

 

 

 

 

 

NOTE 5 — DERIVATIVES

We use derivative instruments to manage risks related to foreign currencies, equity prices, interest rates, and credit; to enhance investment returns; and to facilitate portfolio diversification. Our objectives for holding derivatives include reducing, eliminating, and efficiently managing the economic impact of these exposures as effectively as possible. Our derivative programs include strategies that both qualify and do not qualify for hedge accounting treatment.

Foreign Currency

Certain forecasted transactions, assets, and liabilities are exposed to foreign currency risk. We monitor our foreign currency exposures daily to maximize the economic effectiveness of our foreign currency hedge positions. Option and forward contracts are used to hedge a portion of forecasted international revenue and are designated as cash flow hedging instruments. Principal currencies hedged include the euro, Japanese yen, British pound, Canadian dollar, and Australian dollar.

Foreign currency risks related to certain non-U.S. dollar denominated securities are hedged using foreign exchange forward contracts that are designated as fair value hedging instruments.

Certain options and forwards not designated as hedging instruments are also used to manage the variability in foreign exchange rates on certain balance sheet amounts and to manage other foreign currency exposures.

Equity

Securities held in our equity investments portfolio are subject to market price risk. Market price risk is managed relative to broad-based global and domestic equity indices using certain convertible preferred investments, options, futures, and swap contracts not designated as hedging instruments. In the past, to hedge our price risk, we also used and designated equity derivatives as hedging instruments, including puts, calls, swaps, and forwards.

15


PART I

Item 1

 

Other

Interest Rate

Securities held in our fixed-income portfolio are subject to different interest rate risks based on their maturities. We manage the average maturity of our fixed-income portfolio to achieve economic returns that correlate to certain broad-based fixed-income indices using exchange-traded option and futures contracts, and over-the-counter swap and option contracts, none of which are designated as hedging instruments.

In addition, we use “To Be Announced” forward purchase commitments of mortgage-backed assets to gain exposure to agency mortgage-backed securities. These meet the definition of a derivative instrument in cases where physical delivery of the assets is not taken at the earliest available delivery date.

Credit

Our fixed-income portfolio is diversified and consists primarily of investment-grade securities. We use credit default swap contracts, not designated as hedging instruments, to manage credit exposures relative to broad-based indices and to facilitate portfolio diversification. We use credit default swaps as they are a low-cost method of managing exposure to individual credit risks or groups of credit risks.

Credit-Risk-Related Contingent Features

Certain of our counterparty agreements for derivative instruments contain provisions that require our issued and outstanding long-term unsecured debt to maintain an investment grade credit rating and require us to maintain minimum liquidity of $1.0 billion. To the extent we fail to meet these requirements, we will be required to post collateral, similar to the standard convention related to over-the-counter derivatives. As of December 31, 2018, our long-term unsecured debt rating was AAA, and cash investments were in excess of $1.0 billion. As a result, no collateral was required to be posted.

The following table presents the notional amounts of our outstanding derivative instruments measured in U.S. dollar equivalents:

 

(In millions)

 

December 31,

2018

 

 

June 30,

2018

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Designated as Hedging Instruments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts sold

 

$

8,954

 

 

$

11,101

 

 

 

 

 

 

 

 

 

 

Not Designated as Hedging Instruments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts purchased

 

 

10,171

 

 

 

9,425

 

Foreign exchange contracts sold

 

 

12,089

 

 

 

13,374

 

Equity contracts purchased

 

 

51

 

 

 

49

 

Equity contracts sold

 

 

7

 

 

 

5

 

Other contracts purchased

 

 

1,302

 

 

 

878

 

Other contracts sold

 

 

468

 

 

 

472

 

 

 

 

 

 

 

 

 

 

 

16


PART I

Item 1

 

Fair Values of Derivative Instruments

The following table presents our derivative instruments:

 

 

 

 

Derivative

 

 

 

Derivative

 

 

Derivative

 

 

Derivative

 

(In millions)

 

Assets

 

 

 

Liabilities

 

 

Assets

 

 

Liabilities

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31,

2018

 

 

June 30,

2018

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Changes in Fair Value Recorded in Other Comprehensive Income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Designated as Hedging Instruments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

$

112

 

 

$

0

 

 

$

174

 

 

$

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Changes in Fair Value Recorded in Net Income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Designated as Hedging Instruments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

 

2

 

 

 

(133

)

 

 

95

 

 

 

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Not Designated as Hedging Instruments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

 

113

 

 

 

(93

)

 

 

256

 

 

 

(197

)

Equity contracts

 

 

2

 

 

 

(59

)

 

 

2

 

 

 

(7

)

Other contracts

 

 

13

 

 

 

(9

)

 

 

11

 

 

 

(3

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross amounts of derivatives

 

 

242

 

 

 

(294

)

 

 

538

 

 

 

(207

)

Gross amounts of derivatives offset in the balance sheet

 

 

(128

)

 

 

128

 

 

 

(152

)

 

 

153

 

Cash collateral received

 

 

 0

 

 

 

(112

)

 

 

0

 

 

 

(235

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net amounts of derivatives

 

$

114

 

 

$

(278

)

 

$

386

 

 

$

(289

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Reported as

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Short-term investments

 

$

(11

)

 

$

0

 

 

$

104

 

 

$

0

 

Other current assets

 

 

121

 

 

 

0

 

 

 

260

 

 

 

0

 

Other long-term assets

 

 

4

 

 

 

0

 

 

 

22

 

 

 

0

 

Other current liabilities

 

 

0

 

 

 

(269

)

 

 

0

 

 

 

(288

)

Other long-term liabilities

 

 

0

 

 

 

(9

)

 

 

0

 

 

 

(1

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

114

 

 

$

(278

)

 

$

386

 

 

$

(289

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gross derivative assets and liabilities subject to legally enforceable master netting agreements for which we have elected to offset were $233 million and $294 million, respectively, as of December 31, 2018, and $533 million and $207 million, respectively, as of June 30, 2018.

The following table presents the fair value of our derivatives instruments on a gross basis:

 

(In millions)

 

Level 1

 

 

 

Level 2

 

 

Level 3

 

 

Total

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2018

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Derivative assets

 

$

2

 

 

$

238

 

 

$

2

 

 

$

242

 

Derivative liabilities

 

 

(3

)

 

 

(291

)

 

 

0

 

 

 

(294

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

June 30, 2018

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Derivative assets

 

 

1

 

 

 

535

 

 

 

2

 

 

 

538

 

Derivative liabilities

 

 

(1

)

 

 

(206

)

 

 

0

 

 

 

(207

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

17


PART I

Item 1

 

Fair Value Hedge Gains (Losses)

We recognized in other income (expense), net the following gains (losses) on contracts designated as fair value hedges and their related hedged items:

 

(In millions)

 

Three Months Ended

December 31,

 

 

Six Months Ended

December 31,

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2018

 

 

2017

 

 

 

2018

 

 

 

2017

 

 

 

 

 

 

 

 

 

 

 

 

Foreign Exchange Contracts

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Derivatives

 

$

(139

)

 

$

14

 

 

$

11

 

 

$

36

 

Hedged items

 

 

184

 

 

 

12

 

 

 

62

 

 

 

10

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total amount of ineffectiveness

 

$

45

 

 

$

26

 

 

$

73

 

 

$

46

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Equity Contracts

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Derivatives

 

$

0

 

 

$

(71

)

 

$

0

 

 

$

(307

)

Hedged items

 

 

0

 

 

 

71

 

 

 

0

 

 

 

307

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total amount of ineffectiveness

 

$

0

 

 

$

0

 

 

$

0

 

 

$

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amount of equity contracts excluded from effectiveness assessment

 

$

0

 

  

$

20

 

 

$

0

 

 

$

60

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash Flow Hedge Gains (Losses)

We recognized the following gains (losses) on foreign exchange contracts designated as cash flow hedges:

 

(In millions)

 

Three Months Ended

December 31,

 

 

Six Months Ended

December 31,

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2018

 

 

2017

 

 

 

2018

 

 

 

2017

 

 

 

 

 

 

 

 

 

 

 

 

Effective Portion

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Gains recognized in other comprehensive income (loss), net of tax of $3, $1, $3, and $1

 

$

70

 

 

$

10

 

 

$

114

 

 

$

15

 

Gains reclassified from accumulated other comprehensive income (loss) into revenue

 

 

88

 

 

 

19

 

 

 

180

 

 

 

130

 

 

 

 

 

 

 

 

 

 

 

 

Amount Excluded from Effectiveness Assessment and Ineffective Portion

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Losses recognized in other income (expense), net

 

 

(14

)

 

 

(73

)

 

 

(41

)

 

 

(164

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

We estimate that $116 million of net derivative gains included in AOCI as of December 31, 2018 will be reclassified into earnings within the following 12 months. No significant amounts of gains (losses) were reclassified from AOCI into earnings as a result of forecasted transactions that failed to occur for the three and six months ended December 31, 2018.

Non-designated Derivative Gains (Losses)

We recognized in other income (expense), net the following gains (losses) on derivatives not designated as hedging instruments:

 

(In millions)

 

Three Months Ended

December 31,

 

 

Six Months Ended

December 31,

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2018

 

 

2017

 

 

 

2018

 

 

 

2017

 

 

 

 

 

 

 

 

 

 

 

 

Foreign exchange contracts

 

$

(79

)

 

$

(115

)

 

$

(109

)

 

$

(184

)

Equity contracts

 

 

0

 

 

 

(49

)

 

 

1

 

 

 

(78

)

Other contracts

 

 

8

 

 

 

(2

)

 

 

4

 

 

 

9

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

(71

)

 

$

(166

)

 

$

(104

)

 

$

(253

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

18


PART I

Item 1

 

NOTE 6  INVENTORIES

The components of inventories were as follows:

 

(In millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31,

2018

 

 

June 30,

2018

 

 

 

 

Raw materials

 

$

455

 

 

$

655

 

Work in process

 

 

61

 

 

 

54

 

Finished goods

 

 

1,445

 

 

 

1,953

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

1,961

 

 

$

  2,662

 

 

 

 

 

 

 

 

 

 

 

NOTE 7 — BUSINESS COMBINATIONS

GitHub Inc.

On October 25, 2018, we acquired GitHub, Inc. in a $7.5 billion stock transaction (inclusive of total cash payments of $1.3 billion in respect of vested GitHub equity awards and an indemnity escrow). The acquisition is expected to empower developers to achieve more at every stage of the development lifecycle, accelerate enterprise use of GitHub, and bring Microsoft’s developer tools and services to new audiences. The financial results of GitHub have been included in our consolidated financial statements since the date of the acquisition. GitHub is reported as part of our Intelligent Cloud segment.

The purchase price allocation as of the date of the acquisition was based on a preliminary valuation and is subject to revision as more detailed analyses are completed and additional information about the fair value of assets acquired and liabilities assumed becomes available.

The major classes of assets and liabilities to which we have preliminarily allocated the purchase price were as follows:

 

(In millions)

 

 

 

 

 

 

 

 

 

Cash, cash equivalents, and short-term investments

 

$

234

 

Goodwill 

 

 

5,441

 

Intangible assets

 

 

1,298

 

Other assets

 

 

157

 

Other liabilities

 

 

(206

)

 

 

 

 

 

 

 

 

 

 

Total

 

$

  6,924

 

 

 

 

 

 

 

The goodwill recognized in connection with the acquisition is primarily attributable to anticipated synergies from future growth and is not expected to be deductible for tax purposes. We assigned the goodwill to our Intelligent Cloud segment.

Following are the details of the purchase price allocated to the intangible assets acquired:

 

(In millions)

 

Amount

 

 

Weighted

Average Life

  

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Customer-related

 

$

679

 

 

 

8 years

 

Technology-based

 

 

447

 

 

 

5 years

 

Marketing-related

 

 

170

 

 

 

10 years

 

Contract-based

 

 

2

 

 

 

2 years

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

  1,298

 

 

 

7 years

 

 

 

 

 

 

 

 

 

 

Transactions recognized separately from the preliminary purchase price allocation were approximately $600 million, primarily related to equity awards recognized as expense over the related service period.

19


PART I

Item 1

 

Other

For the six months ended December 31, 2018, we completed 11 additional acquisitions for $959 million, substantially all of which were paid in cash. These entities have been included in our consolidated results of operations since their respective acquisition dates.

 

NOTE 8 — GOODWILL

Changes in the carrying amount of goodwill were as follows:

 

(In millions)

 

June 30,

2018

 

 

Acquisitions

 

 

Other

 

 

December 31,

2018

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Productivity and Business Processes

 

$

23,823

 

 

$

326

 

 

$

(68

)

 

$

24,081

 

Intelligent Cloud

 

 

5,703

 

 

 

5,484

(a)

 

 

(20

)

 

 

11,167

 

More Personal Computing

 

 

6,157

 

 

 

206

 

 

 

(34

)

 

 

6,329

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

  35,683

 

 

$

  6,016

 

 

$

  (122

)

 

$

  41,577

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(a)

Includes goodwill of $5.4 billion related to GitHub. See Note 7 – Business Combinations for further information.

 

The measurement periods for the valuation of assets acquired and liabilities assumed end as soon as information on the facts and circumstances that existed as of the acquisition dates becomes available, but do not exceed 12 months. Adjustments in purchase price allocations may require a change in the amounts allocated to goodwill during the periods in which the adjustments are determined.

Any change in the goodwill amounts resulting from foreign currency translations and purchase accounting adjustments are presented as “Other” in the table above. Also included in “Other” are business dispositions and transfers between segments due to reorganizations, as applicable.

 

 

NOTE 9  INTANGIBLE ASSETS

The components of intangible assets, all of which are finite-lived, were as follows:

 

(In millions)

 

Gross
Carrying
Amount

 

 

Accumulated
Amortization

 

 

Net
Carrying
Amount

 

 

Gross
Carrying
Amount

 

Accumulated
Amortization

 

 

Net
Carrying
Amount

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31,

2018

 

 

June 30,

2018

 

 

 

 

 

 

 

 

Technology-based

 

$

7,548

 

 

$

(5,383

)

 

$

2,165

 

 

$

7,220

 

 

$

(5,018

)

 

$

2,202

 

Customer-related

 

 

4,741

 

 

 

(1,487

)

 

 

3,254

 

 

 

4,031

 

 

 

(1,205

)

 

 

2,826

 

Marketing-related

 

 

4,177

 

 

 

(1,197

)

 

 

2,980

 

 

 

4,006

 

 

 

(1,071

)

 

 

2,935

 

Contract-based

 

 

574

 

 

 

(491

)

 

 

83

 

 

 

679

 

 

 

(589

)

 

 

90

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

  17,040

(a)

 

$

  (8,558

)

 

$

 8,482

 

 

$

  15,936

 

 

$

  (7,883

)

 

$

 8,053

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(a)

Includes intangible assets of $1.3 billion related to GitHub. See Note 7 – Business Combinations for further information.

Intangible assets amortization expense was $530 million and $1.1 billion for the three and six months ended December 31, 2018, respectively, and $562 million and $1.1 billion for the three and six months ended December 31, 2017, respectively.

20


PART I

Item 1

 

The following table outlines the estimated future amortization expense related to intangible assets held as of December 31, 2018:

 

(In millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

Year Ending June 30,

 

 

 

 

 

 

2019 (excluding the six months ended December 31, 2018)

 

$

871

 

2020

 

 

1,503

 

2021

 

 

1,282

 

2022

 

 

1,182

 

2023

 

 

1,009

 

Thereafter

 

 

2,635

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

8,482

 

 

 

 

 

 

 

NOTE 10  DEBT

Short-term Debt

As of December 31, 2018 and June 30, 2018, we had no commercial paper issued or outstanding. Effective August 31, 2018, we terminated our credit facilities, which served as back-up for our commercial paper program.

Long-term Debt

As of December 31, 2018, the total carrying value and estimated fair value of our long-term debt, including the current portion, were $73.2 billion and $74.2 billion, respectively. As of June 30, 2018, the total carrying value and estimated fair value of our long-term debt, including the current portion, were $76.2 billion and $77.5 billion, respectively. These estimated fair values are based on Level 2 inputs.

 

21


PART I

Item 1

 

The components of our long-term debt, including the current portion, and the associated interest rates were as follows:

 

(In millions, except interest rates)

 

Face Value

December 31,

2018

 

 

Face Value

June 30,

2018

 

 

Stated

Interest

Rate

 

 

Effective

Interest

Rate

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Notes

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

November 3, 2018

 

$

0

 

 

$

1,750

 

 

 

1.300%

 

 

 

1.396%

 

December 6, 2018

 

 

0

 

 

 

1,250

 

 

 

1.625%

 

 

 

1.824%

 

June 1, 2019

 

 

1,000

 

 

 

1,000

 

 

 

4.200%

 

 

 

4.379%

 

August 8, 2019

 

 

2,500

 

 

 

2,500

 

 

 

1.100%

 

 

 

1.203%

 

November 1, 2019

 

 

18

 

 

 

18

 

 

 

0.500%

 

 

 

0.500%

 

February 6, 2020

 

 

1,500

 

 

 

1,500

 

 

 

1.850%

 

 

 

1.952%

 

February 12, 2020

 

 

1,500

 

 

 

1,500

 

 

 

1.850%

 

 

 

1.935%

 

October 1, 2020

 

 

1,000

 

 

 

1,000

 

 

 

3.000%

 

 

 

3.137%

 

November 3, 2020

 

 

2,250

 

 

 

2,250

 

 

 

2.000%

 

 

 

2.093%

 

February 8, 2021

 

 

500

 

 

 

500

 

 

 

4.000%

 

 

 

4.082%

 

August 8, 2021

 

 

2,750

 

 

 

2,750

 

 

 

1.550%

 

 

 

1.642%

 

December 6, 2021 (a)

 

 

2,001

 

 

 

2,044

 

 

 

2.125%

 

 

 

2.233%

 

February 6, 2022

 

 

1,750

 

 

 

1,750

 

 

 

2.400%

 

 

 

2.520%

 

February 12, 2022

 

 

1,500

 

 

 

1,500

 

 

 

2.375%

 

 

 

2.466%

 

November 3, 2022

 

 

1,000

 

 

 

1,000

 

 

 

2.650%

 

 

 

2.717%

 

November 15, 2022

 

 

750

 

 

 

750

 

 

 

2.125%

 

 

 

2.239%

 

May 1, 2023

 

 

1,000

 

 

 

1,000

 

 

 

2.375%

 

 

 

2.465%

 

August 8, 2023

 

 

1,500

 

 

 

1,500

 

 

 

2.000%

 

 

 

2.101%

 

December 15, 2023

 

 

1,500

 

 

 

1,500

 

 

 

3.625%

 

 

 

3.726%

 

February 6, 2024

 

 

2,250

 

 

 

2,250

 

 

 

2.875%

 

 

 

3.041%

 

February 12, 2025

 

 

2,250

 

 

 

2,250

 

 

 

2.700%

 

 

 

2.772%

 

November 3, 2025

 

 

3,000

 

 

 

3,000

 

 

 

3.125%

 

 

 

3.176%

 

August 8, 2026

 

 

4,000

 

 

 

4,000

 

 

 

2.400%

 

 

 

 2.464%

 

February 6, 2027

 

 

4,000

 

 

 

4,000

 

 

 

3.300%

 

 

 

3.383%

 

December 6, 2028 (a)

 

 

2,001

 

 

 

2,044

 

 

 

3.125%

 

 

 

3.218%

 

May 2, 2033 (a)

 

 

629

 

 

 

642

 

 

 

2.625%

 

 

 

2.690%

 

February 12, 2035

 

 

1,500

 

 

 

1,500

 

 

 

3.500%

 

 

 

3.604%

 

November 3, 2035

 

 

1,000

 

 

 

1,000

 

 

 

4.200%

 

 

 

4.260%

 

August 8, 2036

 

 

2,250

 

 

 

2,250

 

 

 

3.450%

 

 

 

 3.510%

 

February 6, 2037

 

 

2,500

 

 

 

2,500

 

 

 

4.100%

 

 

 

4.152%

 

June 1, 2039

 

 

750

 

 

 

750

 

 

 

5.200%

 

 

 

5.240%

 

October 1, 2040

 

 

1,000

 

 

 

1,000

 

 

 

4.500%

 

 

 

4.567%

 

February 8, 2041

 

 

1,000

 

 

 

1,000

 

 

 

5.300%

 

 

 

5.361%

 

November 15, 2042

 

 

900

 

 

 

900

 

 

 

3.500%

 

 

 

3.571%

 

May 1, 2043

 

 

500

 

 

 

500

 

 

 

3.750%

 

 

 

3.829%

 

December 15, 2043

 

 

500

 

 

 

500

 

 

 

4.875%

 

 

 

4.918%

 

February 12, 2045

 

 

1,750

 

 

 

1,750

 

 

 

3.750%

 

 

 

3.800%

 

November 3, 2045

 

 

3,000

 

 

 

3,000

 

 

 

4.450%

 

 

 

4.492%

 

August 8, 2046

 

 

4,500

 

 

 

4,500

 

 

 

3.700%

 

 

 

3.743%

 

February 6, 2047

 

 

3,000

 

 

 

3,000

 

 

 

4.250%

 

 

 

4.287%

 

February 12, 2055

 

 

2,250

 

 

 

2,250

 

 

 

4.000%

 

 

 

4.063%

 

November 3, 2055

 

 

1,000

 

 

 

1,000

 

 

 

4.750%

 

 

 

4.782%

 

August 8, 2056

 

 

2,250

 

 

 

2,250

 

 

 

3.950%

 

 

 

 4.033%

 

February 6, 2057

 

 

2,000

 

 

 

2,000

 

 

 

4.500%

 

 

 

4.528%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

73,799

 

 

$

76,898

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(a)

Euro-denominated debt securities.

The notes in the table above are senior unsecured obligations and rank equally with our other senior unsecured debt outstanding. Interest on these notes is paid semi-annually, except for the euro-denominated debt securities on which interest is paid annually. As of December 31, 2018 and June 30, 2018, the aggregate debt issuance costs and unamortized discount associated with our long-term debt, including the current portion, were $630 million and $658 million, respectively.

 

22


PART I

Item 1

 

NOTE 11  INCOME TAXES

Effective Tax Rate

Our effective tax rate was 19% and 169% for the three months ended December 31, 2018 and 2017, respectively, and 16% and 98% for the six months ended December 31, 2018 and 2017, respectively. The decrease in our effective tax rate for the three and six months ended December 31, 2018 compared to the prior year was primarily due to the net charge related to the enactment of the TCJA in the second quarter of fiscal year 2018.

Our effective tax rate for the three and six months ended December 31, 2018 was lower than the U.S. federal statutory rate, 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 in Ireland, Singapore, and Puerto Rico, and tax benefits relating to stock-based compensation.

Recent Tax Legislation

On December 22, 2017, the TCJA was enacted into law, which significantly changed existing U.S. tax law and included numerous provisions that affect our business, such as imposing a one-time transition tax on deemed repatriation of deferred foreign income, reducing the U.S. federal statutory tax rate, and adopting a territorial tax system. In fiscal year 2018, the TCJA required us to incur a transition tax on deferred foreign income not previously subject to U.S. income tax at a rate of 15.5% for foreign cash and certain other net current assets, and 8% on the remaining income. The TCJA also reduced the U.S. federal statutory tax rate from 35% to 21% effective January 1, 2018. The TCJA included a provision to tax GILTI of foreign subsidiaries and a base erosion anti-abuse tax (“BEAT”) measure that taxes certain payments between a U.S. corporation and its foreign subsidiaries. The GILTI and BEAT provisions of the TCJA were effective for us beginning July 1, 2018.

The TCJA was effective in the second quarter of fiscal year 2018. We recorded a provisional net charge of $13.8 billion in the second quarter of fiscal year 2018, and $13.7 billion for the fiscal year ended June 30, 2018, related to the TCJA based on reasonable estimates for those tax effects. We adjusted our provisional net charge by recording additional tax expense of $157 million in the second quarter of fiscal year 2019, related to GILTI deferred taxes pursuant to SEC Staff Accounting Bulletin No. 118. As of December 31, 2018, the U.S. Treasury Department and the Internal Revenue Service (“IRS”) are still in the process of issuing various TCJA regulations. Accordingly, future adjustments to the financial statements may be necessary as regulations are issued and when we file our fiscal year 2018 tax returns with the IRS and foreign tax authorities in the current fiscal year.

We recorded an estimated charge of $17.8 billion in the second quarter of fiscal year 2018, and $17.9 billion in fiscal year 2018, related to the one-time transition tax on the deemed repatriation of deferred foreign income, which was included in the provision for income taxes on our consolidated income statements and income taxes on our consolidated balance sheets. To calculate the transition tax, we estimated our deferred foreign income for fiscal year 2018 because these tax returns are not complete or due. Taxable income for fiscal year 2018 will be known once the respective tax returns are completed and filed. In addition, U.S. and foreign audit settlements may significantly impact the estimated transition tax. The impact of the U.S. and foreign audits on the transition tax will be known as the audits are concluded.

In addition, we recorded an estimated benefit of $4.0 billion in the second quarter of fiscal year 2018, and $4.2 billion in fiscal year 2018, from the impact of changes in the tax rate, primarily on deferred tax assets and liabilities, which was included in provision for income taxes on our consolidated income statements and deferred income taxes and long-term income taxes on our consolidated balance sheets. We remeasured our deferred taxes to reflect the reduced rate that will apply when these deferred taxes are settled or realized in future periods. We adjusted our provisional charge by recording additional tax expense of $157 million in the second quarter of fiscal year 2019.

The TCJA subjects a U.S. corporation to tax on its GILTI. Under GAAP, we can make an accounting policy election to either treat taxes due on the GILTI inclusion as a current period expense or factor such amounts into our measurement of deferred taxes. We elected the deferred method, under which we recorded the corresponding deferred tax assets and liabilities on our consolidated balance sheets.

23


PART I

Item 1

 

Uncertain Tax Positions

While we settled a portion of the IRS audit for tax years 2004 to 2006 in the third quarter of fiscal year 2011, a portion of the IRS audit for tax years 2007 to 2009 in the first quarter of fiscal year 2016, and a portion of the IRS audit for tax years 2010 to 2013 in the second quarter of fiscal year 2018, we remain under audit for those years. We continue to be subject to examination by the IRS for tax years 2014 to 2017. In February 2012, the IRS withdrew its 2011 Revenue Agents Report for tax years 2004 to 2006 and reopened the audit phase of the examination. As of December 31, 2018, the primary unresolved issues for this and other open IRS audits are related to transfer pricing. While we believe our allowances for income tax contingencies related to the unresolved issues are adequate, the final resolution of these issues, if unfavorable, could have a material impact on our consolidated financial statements. 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 2018, 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.

While we believe our allowances for all income tax contingencies are adequate, the final resolution of these issues, if unfavorable, could have a material impact on our consolidated financial statements. Income tax contingencies and other income tax liabilities were $15.4 billion and $15.1 billion as of December 31, 2018 and June 30, 2018, respectively, and are included in long-term income taxes on our consolidated balance sheets. This increase was primarily due to current period intercompany transactions and interest accruals.

NOTE 12 — UNEARNED REVENUE

Unearned revenue by segment was as follows:

 

(In millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31,
2018

 

 

June 30,
2018

 

 

 

 

Productivity and Business Processes

 

$

12,635

 

 

$

14,864

 

Intelligent Cloud

 

 

12,551

 

 

 

14,706

 

More Personal Computing

 

 

2,898

 

 

 

3,150

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

28,084

 

 

$

32,720

 

 

 

 

 

 

 

 

 

 

 

Changes in unearned revenue were as follows:

 

(In millions)

 

 

 

 

 

 

 

Six Months Ended December 31, 2018

 

 

 

Balance, beginning of period

 

$

32,720

 

Deferral of revenue

 

 

30,450

 

Recognition of unearned revenue

 

 

(35,086

)

 

 

 

 

 

 

 

Balance, end of period

 

$

28,084

 

 

 

 

 

 

 

Revenue allocated to remaining performance obligations represents contracted revenue that has not yet been recognized (“contracted not recognized revenue”), which includes unearned revenue and amounts that will be invoiced and recognized as revenue in future periods. Contracted not recognized revenue was $72 billion as of December 31, 2018, of which we expect to recognize approximately 60% of the revenue over the next 12 months and the remainder thereafter.

 

 

NOTE 13  LEASES

We have operating and finance leases for datacenters, corporate offices, research and development facilities, retail stores, and certain equipment. Our leases have remaining lease terms of 1 year to 20 years, some of which include options to extend the leases for up to 5 years, and some of which include options to terminate the leases within 1 year.

24


PART I

Item 1

 

The components of lease expense were as follows:

 

(In millions)

 

Three Months Ended

December 31,

 

 

Six Months Ended

December 31,

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2018

 

 

 

2017

 

 

 

2018

 

 

 

2017

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating lease cost

 

$

413

 

 

$

399

 

 

$

823

 

 

$

787

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Finance lease cost:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amortization of right-of-use assets

 

$

84

 

 

$

57

 

 

$

162

 

 

$

105

 

Interest on lease liabilities

 

 

59

 

 

 

44

 

 

 

114

 

 

 

74

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total finance lease cost

 

$

143

 

 

$

101

 

 

$

276

 

 

$

179

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Supplemental cash flow information related to leases was as follows:

 

(In millions)

 

Three Months Ended

December 31,

 

 

Six Months Ended

December 31,

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2018

 

 

 

2017

 

 

 

2018

 

 

 

2017

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cash paid for amounts included in the measurement of lease liabilities:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating cash flows from operating leases

 

$

407

 

 

$

375

 

 

$

804

 

 

$

744

 

Operating cash flows from finance leases

 

 

59

 

 

 

45

 

 

 

114

 

 

 

75

 

Financing cash flows from finance leases

 

 

54

 

 

 

31

 

 

 

101

 

 

 

56

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Right-of-use assets obtained in exchange for lease obligations:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating leases

 

 

472

 

 

 

308

 

 

 

968

 

 

 

699

 

Finance leases

 

 

645

 

 

 

650

 

 

 

1,064

 

 

 

1,378

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Supplemental balance sheet information related to leases was as follows:

 

(In millions, except lease term and discount rate)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31,
2018

 

 

June 30,
2018

 

 

 

 

Operating Leases

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating lease right-of-use assets

 

$

6,806

 

 

$

6,686

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other current liabilities

 

$

1,421

 

 

$

1,399

 

Operating lease liabilities

 

 

5,683

 

 

 

5,568

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total operating lease liabilities

 

$

7,104

 

 

$

6,967

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Finance Leases

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Property and equipment, at cost

 

$

5,554

 

 

$

4,543

 

Accumulated depreciation

 

 

(566

)

 

 

(404

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Property and equipment, net

 

$

4,988

 

 

$

4,139

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other current liabilities

 

$

245

 

 

$

176

 

Other long-term liabilities

 

 

4,965

 

 

 

4,125

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total finance lease liabilities

 

$

5,210

 

 

$

4,301

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Weighted Average Remaining Lease Term

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating leases

 

 

7 years

 

 

 

7 years

 

Finance leases

 

 

13 years

 

 

 

13 years

 

 

 

 

 

 

 

 

 

 

Weighted Average Discount Rate

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating leases

 

 

2.9%

 

 

 

2.7%

 

Finance leases

 

 

4.9%

 

 

 

5.2%

 

 

 

 

 

 

 

 

 

 

 

25


PART I

Item 1

 

Maturities of lease liabilities were as follows:

 

(In millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Year Ending June 30,

 

Operating

Leases

 

 

Finance

Leases

 

 

 

 

2019 (excluding the six months ended December 31, 2018)

 

$

799

 

 

$

241

 

2020

 

 

1,503

 

 

 

479

 

2021

 

 

1,244

 

 

 

487

 

2022

 

 

1,048

 

 

 

495

 

2023

 

 

861

 

 

 

498

 

Thereafter

 

 

2,439

 

 

 

4,934

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total lease payments

 

 

7,894

 

 

 

7,134

 

Less imputed interest

 

 

(790

)

 

 

(1,924

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

7,104

 

 

$

5,210

 

 

 

 

 

 

 

 

 

 

 

As of December 31, 2018, we have additional operating and finance leases, primarily for datacenters, that have not yet commenced of $2.7 billion and $6.4 billion, respectively. These operating and finance leases will commence between fiscal year 2019 and fiscal year 2022 with lease terms of 1 year to 16 years.

 

 

NOTE 14 — CONTINGENCIES

Patent and Intellectual Property Claims

There were 32 patent infringement cases pending against Microsoft as of December 31, 2018, none of which are material individually or in aggregate.

Antitrust, Unfair Competition, and Overcharge Class Actions

Antitrust and unfair competition class action lawsuits were filed against us in British Columbia, Ontario, and Quebec, Canada. All three have been certified on behalf of Canadian indirect purchasers who acquired licenses for Microsoft operating system software and/or productivity application software between 1998 and 2010.

The trial of the British Columbia action commenced in May 2016. Following a mediation, the parties agreed to a global settlement of all three Canadian actions, and submitted the proposed settlement agreement to the courts in all three jurisdictions for approval. The final settlement has been approved by the courts in British Columbia, Ontario, and Quebec, and the claims administration process will commence.

Other Antitrust Litigation and Claims

China State Administration for Industry and Commerce Investigation

In 2014, Microsoft was informed that China’s State Agency for Market Regulation (“SAMR”) (formerly State Administration for Industry and Commerce) had begun a formal investigation relating to China’s Anti-Monopoly Law, and the SAMR conducted onsite inspections of Microsoft offices in Beijing, Shanghai, Guangzhou, and Chengdu. In December 2018, the SAMR met with Microsoft representatives and presented their preliminary views as to certain possible violations of China’s Anti-Monopoly Law, to which they have invited Microsoft to respond. 

26


PART I

Item 1

 

Product-Related Litigation

U.S. Cell Phone Litigation

Microsoft Mobile Oy, a subsidiary of Microsoft, along with other handset manufacturers and network operators, is a defendant in 40 lawsuits filed in the Superior Court for the District of Columbia by individual plaintiffs who allege that radio emissions from cellular handsets caused their brain tumors and other adverse health effects. We assumed responsibility for these claims in our agreement to acquire Nokia’s Devices and Services business and have been substituted for the Nokia defendants. Nine of these cases were filed in 2002 and are consolidated for certain pre-trial proceedings; the remaining cases are stayed. In a separate 2009 decision, the Court of Appeals for the District of Columbia held that adverse health effect claims arising from the use of cellular handsets that operate within the U.S. Federal Communications Commission radio frequency emission guidelines (“FCC Guidelines”) are pre-empted by federal law. The plaintiffs allege that their handsets either operated outside the FCC Guidelines or were manufactured before the FCC Guidelines went into effect. The lawsuits also allege an industry-wide conspiracy to manipulate the science and testing around emission guidelines.

In 2013, the defendants in the consolidated cases moved to exclude the plaintiffs’ expert evidence of general causation on the basis of flawed scientific methodologies. In 2014, the trial court granted in part and denied in part the defendants’ motion to exclude the plaintiffs’ general causation experts. The defendants filed an interlocutory appeal to the District of Columbia Court of Appeals challenging the standard for evaluating expert scientific evidence. In October 2016, the Court of Appeals issued its decision adopting the standard advocated by the defendants and remanding the cases to the trial court for further proceedings under that standard. The plaintiffs have filed supplemental expert evidence, portions of which the defendants have moved to strike. In August 2018, the trial court issued an order striking portions of the plaintiffs’ expert reports.

Canadian Cell Phone Class Action

Microsoft Mobile Oy, along with other handset manufacturers and network operators, is a defendant in a 2013 class action lawsuit filed in the Supreme Court of British Columbia by a purported class of Canadians who have used cellular phones for at least 1,600 hours, including a subclass of users with brain tumors, alleging adverse health effects from cellular phone use. Microsoft was served with the complaint in June 2014 and has been substituted for the Nokia defendants. The litigation has been dormant for more than three years.

Employment-Related Litigation

Moussouris v. Microsoft

Current and former female Microsoft employees in certain engineering and information technology roles brought this class action in federal court in Seattle in 2015, alleging systemic gender discrimination in pay and promotions. The plaintiffs moved to certify the class in October 2017. Microsoft filed an opposition in January 2018, attaching an expert report showing no statistically significant disparity in pay and promotions between similarly situated men and women. In June 2018, the court denied the plaintiffs’ motion for class certification. Plaintiffs sought an interlocutory appeal to the U.S. Court of Appeals for the Ninth Circuit, which was granted in September 2018.

Other Contingencies

We also are subject to a variety of other claims and suits that arise from time to time in the ordinary course of our business. Although management currently believes that resolving claims against us, individually or in aggregate, will not have a material adverse impact on our consolidated financial statements, these matters are subject to inherent uncertainties and management’s view of these matters may change in the future.

As of December 31, 2018, we accrued aggregate legal liabilities of $273 million. While we intend to defend these matters vigorously, adverse outcomes that we estimate could reach approximately $1.0 billion in aggregate beyond recorded amounts are reasonably possible. Were unfavorable final outcomes to occur, there exists the possibility of a material adverse impact on our consolidated financial statements for the period in which the effects become reasonably estimable.

 

 

27


PART I

Item 1

 

NOTE 15  STOCKHOLDERS’ EQUITY

Share Repurchases

On September 20, 2016, our Board of Directors approved a share repurchase program authorizing up to $40.0 billion in share repurchases. This share repurchase program commenced on December 22, 2016, has no expiration date, and may be suspended or discontinued at any time without notice. As of December 31, 2018, $19.5 billion remained of this $40.0 billion share repurchase program.

We repurchased the following shares of common stock under the share repurchase program:

 

(In millions)

 

Shares

 

Amount

 

 

Shares

 

Amount

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fiscal Year

 

 

 

 

2019

 

 

 

 

 

2018

 

 

 

 

 

 

First Quarter

 

 

24

 

 

$

2,600

 

 

 

22

 

 

$

1,600

 

Second Quarter

 

 

57

 

 

 

6,100

 

 

 

22

 

 

 

1,800

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

81

 

 

$

8,700

 

 

 

44

 

 

$

3,400

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The above table excludes shares repurchased to settle employee tax withholding related to the vesting of stock awards. All repurchases were made using cash resources.

Dividends

Our Board of Directors declared the following dividends:

 

Declaration Date

 

Record Date

 

Payment Date

 

 

Dividend

Per Share

 

 

Amount

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fiscal Year 2019

 

 

 

 

 

 

 

 

 

(in millions)

 

 

 

 

 

 

 

 

 

 

 

 

 

September 18, 2018

 

November 15, 2018

 

December 13, 2018

 

 

$

0.46

 

 

$

3,544

 

November 28, 2018

 

February 21, 2019

 

March 14, 2019

 

 

 

0.46

 

 

 

3,535

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

 

 

 

$

0.92

 

 

$

7,079

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fiscal Year 2018

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

September 19, 2017

 

November 16, 2017

 

December 14, 2017

 

 

$

0.42

 

 

$

3,238

 

November 29, 2017

 

February 15, 2018

 

March 8, 2018

 

 

 

0.42

 

 

 

3,232

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

 

 

 

 

 

$

0.84

 

 

$

6,470

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

The dividend declared on November 28, 2018 was included in other current liabilities as of December 31, 2018.

 

 

28


PART I

Item 1

 

NOTE 16 — ACCUMULATED OTHER COMPREHENSIVE INCOME (LOSS)

The following table summarizes the changes in accumulated other comprehensive income (loss) by component:

 

(In millions)

 

Three Months Ended

December 31,

 

 

Six Months Ended

December 31,

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2018

 

 

 

2017

 

 

 

2018

 

 

 

2017

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Derivatives

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, beginning of period

 

$

128

 

 

$

28

 

 

$

173

 

 

$

134

 

Unrealized gains, net of tax of $3, $1, $2, and $1

 

 

71

 

 

 

11

 

 

 

115

 

 

 

15

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Reclassification adjustments for gains included in revenue

 

 

(88

)

 

 

(19

)

 

 

(180

)

 

 

(130

)

Tax expense included in provision for income taxes

 

 

2

 

 

 

1

 

 

 

5

 

 

 

2

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amounts reclassified from accumulated other comprehensive income (loss)

 

 

(86

)

 

 

(18

)

 

 

(175

)

 

 

(128

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net change related to derivatives, net of tax of $1, $0, $(3), and $(1)

 

 

(15

)

 

 

(7

)

 

 

(60

)

 

 

(113

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, end of period

 

$

113

 

 

$

21

 

 

$

113

 

 

$

21

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Investments

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, beginning of period

 

$

(1,178

)

 

$

1,537

 

 

$

(850

)

 

$

1,825

 

Unrealized gains (losses), net of tax of $234, $(211), $148, and $(161)

 

 

879

 

 

 

(390

)

 

 

556

 

 

 

(317

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Reclassification adjustments for (gains) losses included in other income (expense), net

 

 

2

 

 

 

(751

)

 

 

80

 

 

 

(1,306

)

Tax expense (benefit) included in provision for income taxes

 

 

0

 

 

 

263

 

 

 

(16

)

 

 

457

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amounts reclassified from accumulated other comprehensive income (loss)

 

 

2

 

 

 

(488

)

 

 

64

 

 

 

(849

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net change related to investments, net of tax of $234, $(474), $164, and $(618)

 

 

881

 

 

 

(878

)

 

 

620

 

 

 

(1,166

)

Cumulative effect of accounting changes

 

 

0

 

 

 

0

 

 

 

(67

)

 

 

0

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, end of period

 

$

(297

)

 

$

659

 

 

$

(297

)

 

$

659

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Translation Adjustments and Other

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, beginning of period

 

$

(1,565

)

 

$

(1,039

)

 

$

(1,510

)

 

$

(1,332

)

Translation adjustments and other, net of tax of $(1), $0, $(1), and $(1)

 

 

(264

)

 

 

(40

)

 

 

(319

)

 

 

253

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, end of period

 

$

  (1,829

)

 

$

  (1,079

)

 

$

(1,829

)

 

$

(1,079

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Accumulated other comprehensive loss, end of period

 

$

(2,013

)

 

$

(399

)

 

$

(2,013

)

 

$

(399

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

NOTE 17  SEGMENT INFORMATION AND GEOGRAPHIC DATA

In its operation of the business, management, including our chief operating decision maker, who is also our Chief Executive Officer, reviews certain financial information, including segmented internal profit and loss statements prepared on a basis not consistent with GAAP. During the periods presented, we reported our financial performance based on the following segments: Productivity and Business Processes, Intelligent Cloud, and More Personal Computing.

29


PART I

Item 1

 

Our reportable segments are described below.

Productivity and Business Processes

Our Productivity and Business Processes segment consists of products and services in our portfolio of productivity, communication, and information services, spanning a variety of devices and platforms. This segment primarily comprises:

 

Office Commercial, including Microsoft Office 365 subscriptions and Office licensed on-premises, comprising Office, Exchange, SharePoint, Skype for Business, and Microsoft Teams, and related Client Access Licenses (“CALs”).

 

Office Consumer, including Office 365 subscriptions and Office licensed on-premises, and Office Consumer Services, including Skype, Outlook.com, and OneDrive.

 

LinkedIn, including Talent Solutions, Marketing Solutions, and Premium Subscriptions.

 

Microsoft Dynamics business solutions, including Dynamics ERP on-premises, Dynamics CRM on-premises, and Dynamics 365, a set of cloud-based applications across ERP and CRM.

Intelligent Cloud

Our Intelligent Cloud segment consists of our public, private, and hybrid server products and cloud services that can power modern business. This segment primarily comprises:

 

Server products and cloud services, including Microsoft SQL Server, Windows Server, Visual Studio, System Center, and related CALs, Microsoft Azure, and GitHub.

 

Enterprise Services, including Premier Support Services and Microsoft Consulting Services.

More Personal Computing

Our More Personal Computing segment consists of products and services geared towards harmonizing the interests of end users, developers, and IT professionals across all devices. This segment primarily comprises:

 

Windows, including Windows original equipment manufacturer (“OEM”) licensing and other non-volume licensing of the Windows operating system; Windows Commercial, comprising volume licensing of the Windows operating system, Windows cloud services, and other Windows commercial offerings; patent licensing; Windows Internet of Things (“IoT”); and MSN advertising.

 

Devices, including Microsoft Surface, PC accessories, and other intelligent devices.

 

Gaming, including Xbox hardware and Xbox software and services, comprising Xbox Live transactions, subscriptions, and advertising (“Xbox Live”), video games, and third-party video game royalties.

 

Search.

Revenue and costs are generally directly attributed to our segments. However, due to the integrated structure of our business, certain revenue recognized and costs incurred by one segment may benefit other segments. Revenue from certain contracts is allocated among the segments based on the relative value of the underlying products and services, which can include allocation based on actual prices charged, prices when sold separately, or estimated costs plus a profit margin. Cost of revenue is allocated in certain cases based on a relative revenue methodology. Operating expenses that are allocated primarily include those relating to marketing of products and services from which multiple segments benefit and are generally allocated based on relative gross margin.

In addition, certain costs incurred at a corporate level that are identifiable and that benefit our segments are allocated to them. These allocated costs include costs of: legal, including settlements and fines; information technology; human resources; finance; excise taxes; field selling; shared facilities services; and customer service and support. Each allocation is measured differently based on the specific facts and circumstances of the costs being allocated. Certain corporate-level activity is not allocated to our segments, including impairment and restructuring expenses.

30


PART I

Item 1

 

Segment revenue and operating income were as follows during the periods presented:

 

(In millions)

 

Three Months Ended

December 31,

 

Six Months Ended

December 31,

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2018

 

 

2017

 

 

 

2018

 

 

 

2017

 

  

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

Productivity and Business Processes

 

$

10,100

 

 

$

8,953

 

 

$

19,871

 

 

$

17,191

 

Intelligent Cloud

 

 

9,378

 

 

 

7,795

 

 

 

17,945

 

 

 

14,717

 

More Personal Computing

 

 

12,993

 

 

 

12,170

 

 

 

23,739

 

 

 

21,548

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

32,471

 

 

$

28,918

 

 

$

61,555

 

 

$

53,456

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating Income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Productivity and Business Processes

 

$

4,015

 

 

$

3,337

 

 

$

7,896

 

 

$

6,343

 

Intelligent Cloud

 

 

3,279

 

 

 

2,832

 

 

 

6,210

 

 

 

4,969

 

More Personal Computing

 

 

2,964

 

 

 

2,510

 

 

 

6,107

 

 

 

5,075

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

10,258

 

 

$

8,679

 

 

$

20,213

 

 

$

16,387

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

No sales to an individual customer or country other than the United States accounted for more than 10% of revenue for the three or six months ended December 31, 2018 or 2017. Revenue, classified by the major geographic areas in which our customers were located, was as follows:

 

(In millions)

 

Three Months Ended

December 31,

 

 

Six Months Ended

December 31,

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2018

 

 

2017

 

 

 

2018

 

 

 

2017

 

 

 

 

 

 

 

 

 

 

 

 

 

United States (a)

 

$

16,787

 

 

$

15,110

 

 

$

31,527

 

 

$

27,657

 

Other countries

 

 

15,684

 

 

 

13,808

 

 

 

30,028

 

 

 

25,799

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

32,471

 

 

$

28,918

 

 

$

61,555

 

 

$

53,456

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

(a)

Includes billings to OEMs and certain multinational organizations because of the nature of these businesses and the impracticability of determining the geographic source of the revenue.

Revenue from external customers, classified by significant product and service offerings, was as follows:

 

(In millions)

 

Three Months Ended

December 31,

 

 

Six Months Ended

December 31,

 

  

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2018

 

 

2017

 

 

 

2018

 

 

 

2017

 

 

Office products and cloud services

 

$

7,747

 

 

$

7,075

 

 

$

15,369

 

 

$

13,651

 

Server products and cloud services

 

 

7,791

 

 

 

6,299

 

 

 

14,849

 

 

 

11,796

 

Windows

 

 

4,758

 

 

 

4,839

 

 

 

9,659

 

 

 

9,482

 

Gaming

 

 

4,232

 

 

 

3,920

 

 

 

6,970

 

 

 

5,816

 

Search advertising

 

 

1,976

 

 

 

1,820

 

 

 

3,764

 

 

 

3,459

 

LinkedIn

 

 

1,693

 

 

 

1,312

 

 

 

3,223

 

 

 

2,460

 

Devices

 

 

1,948

 

 

 

1,478

 

 

 

3,209

 

 

 

2,632

 

Enterprise Services

 

 

1,521

 

 

 

1,435

 

 

 

2,971

 

 

 

2,806

 

Other

 

 

805

 

 

 

740

 

 

 

1,541

 

 

 

1,354

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

32,471

 

 

$

28,918

 

 

$

61,555

 

 

$

53,456

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Our commercial cloud revenue, which includes Office 365 commercial, Azure, the commercial portion of LinkedIn, Dynamics 365, and other commercial cloud properties, was $9.0 billion and $17.5 billion for the three and six months ended December 31, 2018, respectively, and $6.1 billion and $11.9 billion for the three and six months ended December 31, 2017, respectively. These amounts are primarily included in Office products and cloud services, Server products and cloud services, and LinkedIn in the table above.

Assets are not allocated to segments for internal reporting presentations. A portion of amortization and depreciation is included with various other costs in an overhead allocation to each segment; it is impracticable for us to separately identify the amount of amortization and depreciation by segment that is included in the measure of segment profit or loss.

 

 

31


PART I

Item 1

 

REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM

To the Stockholders and the Board of Directors of Microsoft Corporation

Results of Review of Interim Financial Information

We have reviewed the accompanying consolidated balance sheet of Microsoft Corporation and subsidiaries (the "Company") as of December 31, 2018, the related consolidated statements of income, comprehensive income, cash flows, and stockholders’ equity for the three-month and six-month periods ended December 31, 2018 and 2017, and the related notes (collectively referred to as the “interim financial information”).  Based on our reviews, we are not aware of any material modifications that should be made to the accompanying interim financial information for it to be in conformity with accounting principles generally accepted in the United States of America.

We have previously audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) (“PCAOB”), the consolidated balance sheet of the Company as of June 30, 2018, and the related consolidated statements of income, comprehensive income, cash flows, and stockholders’ equity for the year then ended (not presented herein); and in our report dated August 3, 2018, we expressed an unqualified opinion on those consolidated financial statements and included an explanatory paragraph regarding a change in accounting principles. In our opinion, the information set forth in the accompanying consolidated balance sheet as of June 30, 2018, is fairly stated, in all material respects, in relation to the consolidated balance sheet from which it has been derived.

Basis for Review Results

This interim financial information is the responsibility of the Company's management.  We are a public accounting firm registered with the PCAOB and are required to be independent with respect to the Company in accordance with the U.S. federal securities laws and the applicable rules and regulations of the PCAOB and the Securities and Exchange Commission.

We conducted our reviews in accordance with standards of the PCAOB. A review of interim financial information consists principally of applying analytical procedures and making inquiries of persons responsible for financial and accounting matters. It is substantially less in scope than an audit conducted in accordance with the standards of the PCAOB, the objective of which is the expression of an opinion regarding the financial statements taken as a whole. Accordingly, we do not express such an opinion.

/S/ DELOITTE & TOUCHE LLP

Seattle, Washington

January 30, 2019

 

 

 

32


PART I

Item 2

 

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

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, 2018, 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 licensing and supporting an array of software products; offering a wide range of cloud-based and other services to people and businesses; 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 2019 compared with the second quarter of fiscal year 2018 included:

 

Commercial cloud revenue, which includes Microsoft Office 365 commercial, Microsoft Azure, the commercial portion of LinkedIn, Microsoft Dynamics 365, and other commercial cloud properties, increased 48% to $9.0 billion.

 

Office Commercial revenue increased 11%, driven by Office 365 commercial growth of 34%.

 

Office Consumer revenue increased 1%, with continued growth in Office 365 consumer subscribers to 33.3 million.

 

LinkedIn revenue increased 29%, with strong engagement highlighted by LinkedIn sessions growth of 30%.

 

Dynamics revenue increased 17%, driven by Dynamics 365 growth of 51%.  

 

Server products and cloud services revenue, including GitHub, increased 24%, driven by Azure growth of 76%.  

 

Enterprise Services revenue increased 6%.

 

Windows original equipment manufacturer licensing (“Windows OEM”) revenue decreased 5%.

 

Windows Commercial revenue increased 13%.

 

Microsoft Surface revenue increased 39%.

33


PART I

Item 2

 

 

Gaming revenue increased 8%, with Xbox software and services growth of 31%.  

 

Search advertising revenue, excluding traffic acquisition costs, increased 14%.

We have recast certain prior period commercial cloud metrics to include the commercial portion of LinkedIn to provide a comparable view of our commercial cloud business performance. The commercial portion of LinkedIn includes LinkedIn Recruiter, Sales Navigator, premium business subscriptions, and other services for organizations.

On October 25, 2018, we acquired GitHub, Inc. in a $7.5 billion stock transaction (inclusive of total cash payments of $1.3 billion in respect of vested GitHub equity awards and an indemnity escrow). The financial results of GitHub have been included in our consolidated financial statements since the date of the acquisition. GitHub is reported as part of our Intelligent Cloud segment. Refer to Note 7 – Business Combinations of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion.

On December 22, 2017, the Tax Cuts and Jobs Act (“TCJA”) was enacted into law, which significantly changed existing U.S. tax law and includes numerous provisions that affect our business. We recorded a provisional net charge of $13.8 billion in the second quarter of fiscal year 2018, and $13.7 billion in fiscal year 2018, related to the TCJA. We adjusted our provisional net charge by recording additional tax expense of $157 million in the second quarter of fiscal year 2019. Refer to Note 11 – Income Taxes of the Notes to 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 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. Strengthening of foreign currencies relative to the U.S. dollar throughout fiscal year 2018 positively impacted reported revenue and increased reported expenses from our international operations. Strengthening of the U.S. dollar relative to certain foreign currencies in the first and second quarters of fiscal year 2019 has not significantly impacted reported revenue or expenses from our international operations.

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.

34


PART I

Item 2

 

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).

SUMMARY RESULTS OF OPERATIONS

 

(In millions, except percentages and per share amounts)

 

 

Three Months Ended

December 31,

 

 

Percentage

Change

 

 

Six Months Ended

December 31,

 

 

Percentage

Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2018

 

 

 

2017

 

 

 

 

 

 

 

2018

 

 

 

2017

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

$

32,471

 

 

$

28,918

 

 

 

12%

 

 

$

61,555

 

 

$

53,456

 

 

 

15%

 

Gross margin

 

 

20,048

 

 

 

17,854

 

 

 

12%

 

 

 

39,227

 

 

 

34,114

 

 

 

15%

 

Operating income

 

 

10,258

 

 

 

8,679

 

 

 

18%

 

 

 

20,213

 

 

 

16,387

 

 

 

23%

 

Net income (loss)

 

 

8,420

 

 

 

(6,302

)

 

 

*

 

 

 

17,244

 

 

 

274

 

 

 

*

 

Diluted earnings (loss) per share

 

 

1.08

 

 

 

(0.82

)

 

 

*

 

 

 

2.22

 

 

 

0.04

 

 

 

*

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Non-GAAP net income

 

 

8,577

 

 

 

7,498

 

 

 

14%

 

 

 

17,401

 

 

 

14,074

 

 

 

24%

 

Non-GAAP diluted earnings per share

 

 

1.10

 

 

 

0.96

 

 

 

15%

 

 

 

2.24

 

 

 

1.80

 

 

 

24%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

*

Not meaningful.

Non-GAAP net income and diluted earnings per share (“EPS”) exclude the net charge related to the TCJA. 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.

Three Months Ended December 31, 2018 Compared with Three Months Ended December 31, 2017

Revenue increased $3.6 billion or 12%, 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 Surface and Gaming.

Gross margin increased $2.2 billion or 12%, driven by growth across each of our segments. Gross margin percentage was relatively unchanged, due to gross margin percentage decline in Productivity and Business Processes and More Personal Computing, offset by favorable segment sales mix. Gross margin included a 5 percentage point improvement in commercial cloud, primarily from Azure.

Operating income increased $1.6 billion or 18%, driven by growth across each of our segments.

Key changes in expenses were:

 

Cost of revenue increased $1.4 billion or 12%, driven by growth in commercial cloud and Surface.

 

Research and development expenses increased $566 million or 16%, driven by investments in cloud engineering.

 

Sales and marketing expenses increased $26 million or 1%, driven by investments in commercial sales capacity, offset in part by a decrease in marketing.

Current year net income and diluted EPS were negatively impacted by the net charge related to TCJA, which resulted in a decrease to net income and diluted EPS of $157 million and $0.02, respectively. Prior year net loss and diluted EPS were negatively impacted by the net charge related to TCJA, which resulted in a decrease to net income and diluted EPS of $13.8 billion and $1.78, respectively.

35


PART I

Item 2

 

Six Months Ended December 31, 2018 Compared with Six Months Ended December 31, 2017

Revenue increased $8.1 billion or 15%, driven by growth across each of our segments. Intelligent Cloud revenue increased, driven by server products and cloud services. Productivity and Business Processes revenue increased, driven by Office and LinkedIn. More Personal Computing revenue increased, driven by Gaming and Surface.

Gross margin increased $5.1 billion or 15%, driven by growth across each of our segments. Gross margin percentage was relatively unchanged, due to gross margin percentage decline in More Personal Computing and Productivity and Business Processes, offset by gross margin percentage improvement in Intelligent Cloud and favorable segment sales mix. Gross margin included a 5 percentage point improvement in commercial cloud, primarily from Azure.

Operating income increased $3.8 billion or 23%, driven by growth across each of our segments.

Key changes in expenses were:

 

Cost of revenue increased $3.0 billion or 15%, driven by growth in commercial cloud, Gaming, and Surface.

 

Research and development expenses increased $969 million or 14%, driven by investments in cloud engineering.

 

Sales and marketing expenses increased $312 million or 4%, driven by investments in commercial sales capacity, offset in part by a decrease in marketing.

Current year net income and diluted EPS were negatively impacted by the net charge related to TCJA, which resulted in a decrease to net income and diluted EPS of $157 million and $0.02, respectively. Prior year net income and diluted EPS were negatively impacted by the net charge related to TCJA, which resulted in a decrease to net income and diluted EPS of $13.8 billion and $1.76, respectively.

SEGMENT RESULTS OF OPERATIONS

 

(In millions, except percentages)

 

Three Months Ended

December 31,

 

 

Percentage

Change

 

 

Six Months Ended

December 31,

 

 

Percentage

Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2018

 

 

2017

 

 

 

 

 

 

2018

 

 

 

2017

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Revenue

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Productivity and Business Processes

 

$

10,100

 

 

$

8,953

 

 

 

13%

 

 

$

19,871

 

 

$

17,191

 

 

 

16%

 

Intelligent Cloud

 

 

9,378

 

 

 

7,795

 

 

 

20%

 

 

 

17,945

 

 

 

14,717

 

 

 

22%

 

More Personal Computing

 

 

12,993

 

 

 

12,170

 

 

 

7%

 

 

 

23,739

 

 

 

21,548

 

 

 

10%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

32,471

 

 

$

28,918

 

 

 

12%

 

 

$

61,555

 

 

$

53,456

 

 

 

15%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Operating Income

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Productivity and Business Processes

 

$

4,015

 

 

$

3,337

 

 

 

20%

 

 

$

7,896

 

 

$

6,343

 

 

 

24%

 

Intelligent Cloud

 

 

3,279

 

 

 

2,832

 

 

 

16%

 

 

 

6,210

 

 

 

4,969

 

 

 

25%

 

More Personal Computing

 

 

2,964

 

 

 

2,510

 

 

 

18%

 

 

 

6,107

 

 

 

5,075

 

 

 

20%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

10,258

 

 

$

8,679

 

 

 

18%

 

 

$

20,213

 

 

$

16,387

 

 

 

23%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Reportable Segments

Three Months Ended December 31, 2018 Compared with Three Months Ended December 31, 2017

Productivity and Business Processes

Revenue increased $1.1 billion or 13%.

 

Office Commercial revenue increased $669 million or 11%, driven by Office 365 commercial, due to growth in subscribers and average revenue per user, offset in part by lower revenue from products licensed on-premises, reflecting a continued shift to Office 365 commercial.

 

Office Consumer revenue increased $13 million or 1%, driven by Office 365 consumer, due to growth in subscribers, offset in part by lower revenue from products licensed on-premises, reflecting a continued shift to Office 365 consumer.

36


PART I

Item 2

 

 

LinkedIn revenue increased $381 million or 29%, with strong engagement highlighted by LinkedIn sessions growth.

 

Dynamics revenue increased 17%, driven by Dynamics 365 growth.

Operating income increased $678 million or 20%.

 

Gross margin increased $780 million or 11% driven by growth in Office Commercial and LinkedIn. Gross margin percentage decreased, due to an increased mix of cloud offerings, offset in part by gross margin percentage improvement in LinkedIn and Office 365 commercial.  

 

Operating expenses increased $102 million or 3%, driven by investments in LinkedIn and cloud engineering, offset in part by a decrease in marketing.  

Intelligent Cloud

Revenue increased $1.6 billion or 20%.

 

Server products and cloud services revenue, including GitHub, increased $1.5 billion or 24%, driven by Azure. Azure revenue growth was 76%, due to higher infrastructure-as-a-service and platform-as-a-service consumption-based and per user-based services. Server products revenue increased 3%, due to a higher mix of premium licenses for Windows Server and GitHub.

 

Enterprise Services revenue increased $86 million or 6%, driven by growth in Premier Support Services and Microsoft Consulting Services.

Operating income increased $447 million or 16%.

 

Gross margin increased $1.1 billion or 20%, driven by growth in server products and cloud services revenue and cloud services scale and efficiencies. Gross margin percentage increased slightly, due to gross margin percentage improvement in Azure, offset by an increased mix of cloud offerings.

 

Operating expenses increased $644 million or 26%, driven by investments in cloud and artificial intelligence (“AI”) engineering, GitHub, and commercial sales capacity.

More Personal Computing

Revenue increased $823 million or 7%.

 

Windows revenue decreased $81 million or 2%, driven by a decrease in Windows OEM and patent licensing, offset in part by growth in Windows Commercial. Windows OEM revenue decreased 5%. Windows OEM non-Pro revenue declined 11%, below the consumer PC market, with continued pressure in the entry-level category. Windows OEM Pro revenue declined 2%, in line with the commercial PC market. Windows Commercial revenue increased 13%, with continued customer adoption of premium offerings.

 

Surface revenue increased $525 million or 39%, with strong growth across consumer and commercial.

 

Gaming revenue increased $312 million or 8%, driven by Xbox software and services growth of 31%, primarily due to third-party title strength, offset in part by a decline in Xbox hardware of 19% due to the launch of Xbox One X in the second quarter of fiscal year 2018.

 

Search advertising revenue increased $156 million or 9%. Search advertising revenue, excluding traffic acquisition costs, increased 14%, driven by growth in Bing, due to higher revenue per search and search volume.

Operating income increased $454 million or 18%.

 

Gross margin increased $323 million or 6%, driven by growth in Gaming and Search. Gross margin percentage decreased slightly, due to sales mix shift to our lower margin Surface and Gaming businesses.

 

Operating expenses decreased $131 million or 4%, driven by a decline in Windows and Gaming marketing.

37


PART I

Item 2

 

Six Months Ended December 31, 2018 Compared with Six Months Ended December 31, 2017

Productivity and Business Processes

Revenue increased $2.7 billion or 16%.

 

Office Commercial revenue increased $1.6 billion or 14%, driven by Office 365 commercial, due to growth in subscribers and average revenue per user, offset in part by lower revenue from products licensed on-premises, reflecting a continued shift to Office 365 commercial.

 

Office Consumer revenue increased $153 million or 8%, driven by Office 365 consumer, due to growth in subscribers.

 

LinkedIn revenue increased $763 million or 31%, with strong engagement highlighted by LinkedIn sessions growth.

 

Dynamics revenue increased 18%, driven by Dynamics 365 growth.

Operating income increased $1.6 billion or 24%.

 

Gross margin increased $1.9 billion or 14%, driven by growth in Office Commercial and LinkedIn. Gross margin percentage decreased slightly, due to an increased mix of cloud offerings, offset in part by gross margin percentage improvement in LinkedIn and Office 365 commercial.  

 

Operating expenses increased $330 million or 5%, driven by investments in LinkedIn and cloud engineering, offset in part by a decrease in marketing.  

Intelligent Cloud

Revenue increased $3.2 billion or 22%.

 

Server products and cloud services revenue, including GitHub, increased $3.1 billion or 26%, driven by Azure. Azure revenue growth was 76%, due to higher infrastructure-as-a-service and platform-as-a-service consumption-based and per user-based services. Server products revenue increased 6%, due to a higher mix of premium licenses for Windows Server.

 

Enterprise Services revenue increased $165 million or 6%, driven by growth in Premier Support Services and Microsoft Consulting Services.

Operating income increased $1.2 billion or 25%.

 

Gross margin increased $2.4 billion or 24%, 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 $1.1 billion or 23%, driven by investments in cloud and AI engineering, commercial sales capacity, and GitHub.

More Personal Computing

Revenue increased $2.2 billion or 10%.

 

Windows revenue increased $177 million or 2%, driven by growth in Windows Commercial, offset in part by a decline in patent licensing and Windows OEM. Windows Commercial revenue increased 13%, with continued customer adoption of premium offerings. Windows OEM revenue decreased 1%. Windows OEM Pro revenue grew 3%, slightly ahead of the commercial PC market. Windows OEM non-Pro revenue declined 8%, below the consumer PC market, with continued pressure in the entry-level category.

 

Gaming revenue increased $1.2 billion or 20%, driven by Xbox software and services growth of 33%, primarily due to third-party title strength, offset in part by a decline in Xbox hardware of 4%.

 

Surface revenue increased $668 million or 28%, with strong growth across consumer and commercial.

 

Search advertising revenue increased $305 million or 9%. Search advertising revenue, excluding traffic acquisition costs, increased 15%, driven by growth in Bing, due to higher revenue per search and search volume.

38


PART I

Item 2

 

Operating income increased $1.0 billion or 20%.

 

Gross margin increased $870 million or 8%, driven by growth in Gaming, Windows, and Search. Gross margin percentage decreased, due to sales mix shift to lower gross margin Surface and Gaming businesses.

 

Operating expenses decreased $162 million or 3%, driven by a decline in Windows marketing.

OPERATING EXPENSES

Research and Development

 

(In millions, except percentages)

 

Three Months Ended

December 31,

 

 

Percentage

Change

 

 

Six Months Ended

December 31,

 

 

Percentage

Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2018

 

 

2017

 

 

 

 

 

 

2018

 

 

 

2017

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Research and development

 

$

4,070

 

 

$

3,504

 

 

 

16%

 

 

$

8,047

 

 

$

7,078

 

 

 

14%

 

As a percent of revenue

 

 

13%

 

 

 

12%

 

 

 

1ppt

 

 

 

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 December 31, 2018 Compared with Three Months Ended December 31, 2017

Research and development expenses increased $566 million or 16%, driven by investments in cloud engineering.

Six Months Ended December 31, 2018 Compared with Six Months Ended December 31, 2017

Research and development expenses increased $969 million or 14%, driven by investments in cloud engineering.

Sales and Marketing

 

(In millions, except percentages)

 

Three Months Ended

December 31,

 

 

Percentage

Change

 

 

Six Months Ended

December 31,

 

 

Percentage

Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2018

 

 

2017

 

 

 

 

 

 

2018

 

 

 

2017

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sales and marketing

 

$

4,588

 

 

$

4,562

 

 

 

1%

 

 

$

8,686

 

 

$

8,374

 

 

 

4%

 

As a percent of revenue

 

 

14%

 

 

 

16%

 

 

 

(2)ppt

 

 

 

14%

 

 

 

16%

 

 

 

(2)ppt

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sales and marketing expenses include payroll, employee benefits, stock-based compensation expense, and other headcount-related expenses associated with sales and marketing personnel, and the costs of advertising, promotions, trade shows, seminars, and other programs.

Three Months Ended December 31, 2018 Compared with Three Months Ended December 31, 2017

Sales and marketing expenses increased $26 million or 1%, driven by investments in commercial sales capacity, offset in part by a decrease in marketing.

Six Months Ended December 31, 2018 Compared with Six Months Ended December 31, 2017

Sales and marketing expenses increased $312 million or 4%, driven by investments in commercial sales capacity, offset in part by a decrease in marketing.

39


PART I

Item 2

 

General and Administrative

 

(In millions, except percentages)

 

Three Months Ended

December 31,

 

 

Percentage

Change

 

 

Six Months Ended

December 31,

 

 

Percentage

Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2018

 

 

2017

 

 

 

 

 

 

2018

 

 

 

2017

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

General and administrative

 

$

1,132

 

 

$

1,109

 

 

 

2%

 

 

$

2,281

 

 

$

2,275

 

 

 

0%

 

As a percent of revenue

 

 

3%

 

 

 

4%

 

 

 

(1)ppt

 

 

 

4%

 

 

 

4%

 

 

 

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 December 31, 2018 Compared with Three Months Ended December 31, 2017

General and administrative expenses increased $23 million or 2%.

Six Months Ended December 31, 2018 Compared with Six Months Ended December 31, 2017

General and administrative expenses increased slightly.

OTHER INCOME (EXPENSE), NET

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

 

(In millions)

 

Three Months Ended

December 31,

 

 

Six Months Ended

December 31,

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2018

 

 

2017

 

 

2018

 

 

2017

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest and dividends income

 

$

704

 

 

$

530

 

 

$

1,385

 

 

$

1,003

 

Interest expense

 

 

(672

)

 

 

(698

)

 

 

  (1,346

)

 

 

  (1,370

)

Net recognized gains on investments

 

 

94

 

 

 

768

 

 

 

337

 

 

 

1,341

 

Net gains (losses) on derivatives

 

 

41

 

 

 

(84

)

 

 

38

 

 

 

(134

)

Net losses on foreign currency remeasurements

 

 

(74

)

 

 

(60

)

 

 

(69

)

 

 

(69

)

Other, net

 

 

34

 

 

 

34

 

 

 

48

 

 

 

(5

)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total

 

$

127

 

 

$

490

 

 

$

393

 

 

$

766

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

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 December 31, 2018 Compared with Three Months Ended December 31, 2017

Interest and dividends income increased primarily due to higher yields on fixed-income securities. Interest expense decreased primarily driven by 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 primarily due to lower gains on sales of equity investments. Net gains on derivatives includes gains on foreign exchange derivatives in the current period as compared to losses in the prior period.

Six Months Ended December 31, 2018 Compared with Six Months Ended December 31, 2017

Interest and dividends income increased primarily due to higher yields on fixed-income securities. Interest expense decreased primarily driven by 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 primarily due to lower gains on sales of equity investments. Net gains on derivatives includes gains on foreign exchange derivatives in the current period as compared to losses in the prior period.

40


PART I

Item 2

 

INCOME TAXES

Effective Tax Rate

Our effective tax rate was 19% and 169% for the three months ended December 31, 2018 and 2017, respectively, and 16% and 98% for the six months ended December 31, 2018 and 2017, respectively. The decrease in our effective tax rate for the three and six months ended December 31, 2018 compared to the prior year was primarily due to the net charge related to the enactment of the TCJA in the second quarter of fiscal year 2018.

Our effective tax rate for the three and six months ended December 31, 2018 was lower than the U.S. federal statutory rate, 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 in Ireland, Singapore, and Puerto Rico, and tax benefits relating to stock-based compensation.

Recent Tax Legislation

On December 22, 2017, the TCJA was enacted into law, which significantly changed existing U.S. tax law and included numerous provisions that affect our business, such as imposing a one-time transition tax on deemed repatriation of deferred foreign income, reducing the U.S. federal statutory tax rate, and adopting a territorial tax system. In fiscal year 2018, the TCJA required us to incur a transition tax on deferred foreign income not previously subject to U.S. income tax at a rate of 15.5% for foreign cash and certain other net current assets, and 8% on the remaining income. The TCJA also reduced the U.S. federal statutory tax rate from 35% to 21% effective January 1, 2018. The TCJA included a provision to tax global intangible low-taxed income (“GILTI”) of foreign subsidiaries and a base erosion anti-abuse tax (“BEAT”) measure that taxes certain payments between a U.S. corporation and its foreign subsidiaries. The GILTI and BEAT provisions of the TCJA were effective for us beginning July 1, 2018.

The TCJA was effective in the second quarter of fiscal year 2018. We recorded a provisional net charge of $13.8 billion in the second quarter of fiscal year 2018, and $13.7 billion for the fiscal year ended June 30, 2018, related to the TCJA. We adjusted our provisional net charge by recording additional tax expense of $157 million in the second quarter of fiscal year 2019 related to GILTI deferred taxes pursuant to SEC Staff Accounting Bulletin No. 118. Refer to Note 11 – Income Taxes of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion.

Uncertain Tax Positions

While we settled a portion of the Internal Revenue Service (“IRS”) audit for tax years 2004 to 2006 in the third quarter of fiscal year 2011, a portion of the IRS audit for tax years 2007 to 2009 in the first quarter of fiscal year 2016, and a portion of the IRS audit for tax years 2010 to 2013 in the second quarter of fiscal year 2018, we remain under audit for those years. We continue to be subject to examination by the IRS for tax years 2014 to 2017. In February 2012, the IRS withdrew its 2011 Revenue Agents Report for tax years 2004 to 2006 and reopened the audit phase of the examination. As of December 31, 2018, the primary unresolved issues for this and other open IRS audits are related to transfer pricing. While we believe our allowances for income tax contingencies related to the unresolved issues are adequate, the final resolution of these issues, if unfavorable, could have a material impact on our consolidated financial statements. 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 2018, 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

Non-GAAP net income and diluted earnings per share are non-GAAP financial measures which exclude the 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.

41


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 amounts)

 

Three Months Ended

December 31,

 

Percentage

Change

 

Six Months Ended

December 31,

 

Percentage

Change

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

2018

 

 

2017

 

 

 

 

 

2018

 

 

2017

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

8,420

 

$

(6,302

)

 

*

 

$

17,244

 

$

274

 

 

*

 

Net charge related to the TCJA

 

 

157

 

 

13,800

 

 

*

 

 

157

 

 

13,800

 

 

*

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

��

 

 

 

 

 

 

 

Non-GAAP net income

 

$

8,577

 

$

7,498

 

 

14%

 

$

17,401

 

$

14,074

 

 

24%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings (loss) per share

 

$

1.08

 

$

(0.82

)

 

*

 

$

2.22

 

$

0.04

 

 

*

 

Net charge related to the TCJA

 

 

0.02

 

 

1.78

 

 

*

 

 

0.02

 

 

1.76

 

 

*

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Non-GAAP diluted earnings per share

 

$

1.10

 

$

0.96

 

 

15%

 

$

2.24

 

$

1.80

 

 

24%

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

*

Not meaningful.

FINANCIAL CONDITION

Cash, Cash Equivalents, and Investments

Cash, cash equivalents, and short-term investments totaled $127.7 billion and $133.8 billion as of December 31, 2018 and June 30, 2018, respectively. Equity investments were $2.3 billion and $1.9 billion as of December 31, 2018 and June 30, 2018, 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.

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 wi