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MarketScreener Homepage  >  Equities  >  Nasdaq  >  Microsoft Corporation    MSFT

MICROSOFT CORPORATION

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

04/29/2020 | 04:16pm EST

Note About Forward-Looking Statements


This report includes estimates, projections, statements relating to our business
plans, objectives, and expected operating results that are "forward-looking
statements" within the meaning of the Private Securities Litigation Reform Act
of 1995, Section 27A of the Securities Act of 1933, and Section 21E of the
Securities Exchange Act of 1934. Forward-looking statements may appear
throughout this report, including the following sections: "Management's
Discussion and Analysis of Financial Condition and Results of Operations" and
"Risk Factors" (Part II, Item 1A of this Form 10-Q). These forward-looking
statements generally are identified by the words "believe," "project," "expect,"
"anticipate," "estimate," "intend," "strategy," "future," "opportunity," "plan,"
"may," "should," "will," "would," "will be," "will continue," "will likely
result," and similar expressions. Forward-looking statements are based on
current expectations and assumptions that are subject to risks and uncertainties
that may cause actual results to differ materially. We describe risks and
uncertainties that could cause actual results and events to differ materially in
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," "Quantitative and Qualitative Disclosures about Market Risk" (Part
I, Item 3 of this Form 10-Q), and "Risk Factors". We undertake no obligation to
update or revise publicly any forward-looking statements, whether because of new
information, future events, or otherwise.

The following Management's Discussion and Analysis of Financial Condition and
Results of Operations ("MD&A") is intended to help the reader understand the
results of operations and financial condition of Microsoft Corporation. MD&A is
provided as a supplement to, and should be read in conjunction with, our Annual
Report on Form 10-K for the year ended June 30, 2019, and our financial
statements and the accompanying Notes to Financial Statements (Part I, Item 1 of
this Form 10-Q).

                                    OVERVIEW

Microsoft is a technology company whose mission is to empower every person and
every organization on the planet to achieve more. We strive to create local
opportunity, growth, and impact in every country around the world. Our platforms
and tools help drive small business productivity, large business
competitiveness, and public-sector efficiency. They also support new startups,
improve educational and health outcomes, and empower human ingenuity.

We generate revenue by offering a wide range of cloud-based and other services
to people and businesses; licensing and supporting an array of software
products; designing, manufacturing, and selling devices; and delivering relevant
online advertising to a global audience. Our most significant expenses are
related to compensating employees; designing, manufacturing, marketing, and
selling our products and services; datacenter costs in support of our
cloud-based services; and income taxes.

Highlights from the third quarter of fiscal year 2020 compared with the third quarter of fiscal year 2019 included:

• Commercial cloud revenue increased 39% to $13.3 billion.

• Office Commercial revenue increased 13%, driven by Office 365 Commercial

growth of 25%.

• Office Consumer revenue increased 15%, with continued growth in Office 365

        Consumer subscribers to 39.6 million.


  • LinkedIn revenue increased 21%.


  • Dynamics revenue increased 17%, driven by Dynamics 365 growth of 47%.

• Server products and cloud services revenue increased 30%, driven by Azure

        growth of 59%.


  • Enterprise Services revenue increased 6%.

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

        was relatively unchanged.


  • Windows Commercial revenue increased 17%.

• Search advertising revenue, excluding traffic acquisition costs, increased

        1%.


  • Xbox content and services revenue increased 2%.


  • Surface revenue increased 1%.


                                       31
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                                     Item 2



Industry Trends

Our industry is dynamic and highly competitive, with frequent changes in both
technologies and business models. Each industry shift is an opportunity to
conceive new products, new technologies, or new ideas that can further transform
the industry and our business. At Microsoft, we push the boundaries of what is
possible through a broad range of research and development activities that seek
to identify and address the changing demands of customers and users, industry
trends, and competitive forces.

Economic Conditions, Challenges, and Risks


The markets for software, devices, and cloud-based services are dynamic and
highly competitive. Our competitors are developing new software and devices,
while also deploying competing cloud-based services for consumers and
businesses. The devices and form factors customers prefer evolve rapidly, and
influence how users access services in the cloud, and in some cases, the user's
choice of which suite of cloud-based services to use. We must continue to evolve
and adapt over an extended time in pace with this changing environment. The
investments we are making in infrastructure and devices will continue to
increase our operating costs and may decrease our operating margins.

Our success is highly dependent on our ability to attract and retain qualified
employees. We hire a mix of university and industry talent worldwide. We compete
for talented individuals globally by offering an exceptional working
environment, broad customer reach, scale in resources, the ability to grow one's
career across many different products and businesses, and competitive
compensation and benefits. Aggregate demand for our software, services, and
devices is correlated to global macroeconomic and geopolitical factors, which
remain dynamic.

Our international operations provide a significant portion of our total revenue
and expenses. Many of these revenue and expenses are denominated in currencies
other than the U.S. dollar. As a result, changes in foreign exchange rates may
significantly affect revenue and expenses. Strengthening of the U.S. dollar
relative to certain foreign currencies reduced reported revenue and expenses
from our international operations in the first, second, and third quarter of
fiscal year 2020.

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

COVID-19


In March 2020, the World Health Organization declared the outbreak of a novel
strain of the coronavirus ("COVID-19") to be a pandemic. The COVID-19 pandemic
is having widespread, rapidly evolving, and unpredictable impacts on global
society, economies, financial markets, and business practices. Federal and state
governments have implemented measures in an effort to contain the virus,
including social distancing, travel restrictions, border closures, limitations
on public gatherings, work from home, supply chain logistical changes, and
closure of non-essential businesses. To protect the health and well-being of our
employees, suppliers, and customers, we have made substantial modifications to
employee travel policies, implemented retail store and office closures as
employees are advised to work from home, and cancelled or shifted our
conferences and other marketing events to virtual-only through fiscal year 2021.
The COVID-19 pandemic has impacted and may continue to impact our business
operations, including our employees, customers, partners, and communities, and
there is substantial uncertainty in the nature and degree of its continued
effects over time.

In the third quarter of fiscal year 2020, COVID-19 had minimal net impact on our
revenue. In the Productivity and Business Processes and Intelligent Cloud
segments, cloud usage increased, particularly in Microsoft 365 including Teams,
Azure, Windows Virtual Desktop, advanced security solutions, and Power Platform,
as customers shifted to work and learn from home. In the final weeks of the
quarter, there was a slowdown in transactional licensing, particularly in small
and medium businesses, and a reduction in advertising spend in LinkedIn. In the
More Personal Computing segment, Windows OEM and Surface benefited from
increased demand to support remote work and learn scenarios, offset in part by
supply chain constraints in China that improved late in the quarter. Gaming
benefited from increased engagement following stay-at-home guidelines. Search
was negatively impacted by reductions in advertising spend, particularly in the
industries most impacted by COVID-19. The effects of COVID-19 may not be fully
reflected in our financial results until future periods.

                                       32

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                                     Item 2



The extent to which the COVID-19 pandemic impacts our business going forward
will depend on numerous evolving factors we cannot reliably predict, including
the duration and scope of the pandemic; governmental, business, and individuals'
actions in response to the pandemic; and the impact on economic activity
including the possibility of recession or financial market instability. These
factors may adversely impact consumer, business, and government spending on
technology as well as customers' ability to pay for our products and services on
an ongoing basis. This uncertainty also affects management's accounting
estimates and assumptions, which could result in greater variability in a
variety of areas that depend on these estimates and assumptions, including
investments, receivables, and forward-looking guidance. Refer to Risk Factors
(Part II, Item 1A of this Form 10-Q) for a discussion of these factors and other
risks.

Seasonality

Our revenue fluctuates quarterly and is generally higher in the second and fourth quarters of our fiscal year. Second quarter revenue is driven by corporate year-end spending trends in our major markets and holiday season spending by consumers, and fourth quarter revenue is driven by the volume of multi-year on-premises contracts executed during the period.

Reportable Segments


We report our financial performance based on the following segments:
Productivity and Business Processes, Intelligent Cloud, and More Personal
Computing. The segment amounts included in MD&A are presented on a basis
consistent with our internal management reporting. All differences between our
internal management reporting basis and accounting principles generally accepted
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 16 - Segment Information and Geographic Data of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q).

Metrics


We use metrics in assessing the performance of our business and to make informed
decisions regarding the allocation of resources. We disclose metrics to enable
investors to evaluate progress against our ambitions, provide transparency into
performance trends, and reflect the continued evolution of our products and
services. Our commercial and other business metrics are fundamentally connected
based on how customers use our products and services. The metrics are disclosed
in the MD&A or the Notes to Financial Statements (Part I, Item 1 of this Form
10-Q). Financial metrics are calculated based on GAAP results and growth
comparisons relate to the corresponding period of last fiscal year.

Commercial

Our commercial business primarily consists of Server products and cloud services, Office Commercial, Windows Commercial, the commercial portion of LinkedIn, Enterprise Services, and Dynamics. Our commercial metrics allow management and investors to assess the overall health of our commercial business and include leading indicators of future performance.




Commercial remaining performance obligation   Commercial portion of revenue allocated to
                                              remaining performance obligations, which
                                              includes unearned revenue and amounts that will
                                              be invoiced and recognized as revenue in future
                                              periods

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

Commercial cloud gross margin percentage      Gross margin percentage for our commercial cloud
                                              business




                                       33
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                                     Item 2


Productivity and Business Processes and Intelligent Cloud


Metrics related to our Productivity and Business Processes and Intelligent Cloud
segments assess the health of our core businesses within these segments. The
metrics reflect our cloud and on-premises product strategies and trends.



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

                                                               cloud 

services, including Office 365

subscriptions and Office licensed on-premises,

                                                               comprising 

Office, Exchange, SharePoint, Teams,

                                                               Office 365 

Security and Compliance, and Skype

                                                               for 

Business, and related Client Access Licenses

                                                               ("CALs")

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

                                                               365 

subscriptions and Office licensed

                                                               on-premises

Office 365 Commercial seat growth                              The number 

of Office 365 Commercial seats at end

                                                               of period 

where seats are paid users covered by

                                                               an Office 

365 Commercial subscription


Office 365 Consumer subscribers                                The number 

of Office 365 Consumer subscribers at

                                                               end of 

period


Dynamics products and cloud services revenue growth            Revenue from 

Dynamics products and cloud

                                                               services, 

including Dynamics 365, a set of

                                                               cloud-based 

applications across ERP and CRM,

                                                               Dynamics ERP on-premises, and Dynamics CRM
                                                               on-premises

LinkedIn revenue growth                                        Revenue from LinkedIn, including Talent
                                                               Solutions,

Marketing Solutions, and Premium

Subscriptions


Server products and cloud services revenue growth              Revenue from 

Server products and cloud services,

                                                               including 

Azure; SQL Server, Windows Server,

                                                               Visual 

Studio, System Center, and related CALs;

                                                               and GitHub

Enterprise Services revenue growth                             Revenue from 

Enterprise Services, including

                                                               Premier 

Support Services and Microsoft

                                                               Consulting Services




More Personal Computing

Metrics related to our More Personal Computing segment assess the performance of
key lines of business within this segment. These metrics provide strategic
product insights which allow us to assess the performance across our commercial
and consumer businesses. As we have diversity of target audiences and sales
motions within the Windows business, we monitor metrics that are reflective of
those varying motions.



Windows OEM Pro revenue growth                                  Revenue 

from sales of Windows Pro licenses sold

                                                                through the 

OEM channel, which primarily

                                                                addresses 

demand in the commercial market


Windows OEM non-Pro revenue growth                              Revenue 

from sales of Windows non-Pro licenses

                                                                sold 

through the OEM channel, which primarily

                                                                addresses 

demand in the consumer market

Windows Commercial products and cloud services revenue growth Revenue from Windows Commercial, comprising

                                                                volume 

licensing of the Windows operating

                                                                system, 

Windows cloud services, and other

                                                                Windows 

commercial offerings


Surface revenue                                                 Revenue 

from Surface devices and accessories


Xbox content and services revenue growth                        Revenue 

from Xbox content and services,

                                                                comprising 

Xbox Live transactions,

subscriptions, cloud services, and advertising

                                                                ("Xbox 

Live"), video games, and third-party

                                                                video game 

royalties


Search advertising revenue, excluding TAC, growth               Revenue 

from search advertising excluding

                                                                traffic 

acquisition costs ("TAC") paid to Bing

                                                                Ads network publishers




                                       34
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                                     PART I

                                     Item 2



                         SUMMARY RESULTS OF OPERATIONS



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


                                                        2020            2019                              2020            2019

Revenue                                          $    35,021$    30,571               15%     $   104,982$    92,126              14%
Gross margin                                          24,046          20,401               18%          71,243          59,628              19%
Operating income                                      12,975          10,341               25%          39,552          30,554              29%
Net income                                            10,752           8,809               22%          33,079          26,053              27%
Diluted earnings per share                              1.40            1.14               23%            4.30            3.36              28%

Non-GAAP net income                                   10,752           8,809               22%          33,079          26,210              26%
Non-GAAP diluted earnings per share                     1.40            1.14               23%            4.30            3.38              27%





Non-GAAP net income and diluted earnings per share ("EPS") for the nine months
ended March 31, 2019 exclude the net charge related to the Tax Cuts and Jobs Act
("TCJA") of $157 million. 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 March 31, 2020 Compared with Three Months Ended March 31, 2019


Revenue increased $4.5 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
Windows.

Gross margin increased $3.6 billion or 18%, driven by growth across each of our
segments. Gross margin percentage increased, driven by sales mix shift to higher
margin businesses. Commercial cloud gross margin percentage increased 4 points
to 67%, primarily driven by improvement in Azure.

Operating income increased $2.6 billion or 25%, driven by growth across each of our segments.


Key changes in expenses were:

     •  Cost of revenue increased $805 million or 8%, driven by growth in
        commercial cloud.

• Research and development expenses increased $571 million or 13%, driven by

        investments in cloud engineering and LinkedIn.


     •  Sales and marketing expenses increased $346 million or 8%, driven by

investments in LinkedIn and commercial sales, as well as an increase in

        bad debt expense.


  • General and administrative expenses increased $94 million or 8%.

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

Nine Months Ended March 31, 2020 Compared with Nine Months Ended March 31, 2019


Revenue increased $12.9 billion or 14%, driven by growth across each of our
segments. Intelligent Cloud revenue increased, driven by server products and
cloud services. Productivity and Business Processes revenue increased, driven by
Office and LinkedIn. More Personal Computing revenue increased, driven by
Windows and Search advertising, offset in part by a decrease in Gaming.

Gross margin increased $11.6 billion or 19%, driven by growth across each of our
segments. Gross margin percentage increased, driven by sales mix shift to higher
margin businesses. Commercial cloud gross margin percentage increased 5 points
to 67%, primarily driven by improvement in Azure.

Operating income increased $9.0 billion or 29%, driven by growth across each of our segments.


Key changes in expenses were:

     •  Cost of revenue increased $1.2 billion or 4%, driven by growth in
        commercial cloud, offset in part by a decline in Gaming.


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                                     Item 2


• Research and development expenses increased $1.7 billion or 14%, driven by

        investments in cloud engineering, LinkedIn, and Gaming.


     •  Sales and marketing expenses increased $930 million or 7%, driven by
        investments in LinkedIn and commercial sales.


  • General and administrative expenses were relatively unchanged.


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


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

                         SEGMENT RESULTS OF OPERATIONS



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


                                   2020         2019                           2020         2019

Revenue

Productivity and Business
Processes                    $   11,743$ 10,242              15%     $  34,646$ 30,113                 15%
Intelligent Cloud                12,281        9,649              27%        34,995       27,594                 27%
More Personal Computing          10,997       10,680               3%        35,341       34,419                  3%


Total                        $   35,021$ 30,571              15%     $ 104,982$ 92,126                 14%


Operating Income

Productivity and Business
Processes                    $    4,788$  3,979              20%     $  14,752$ 11,875                 24%
Intelligent Cloud                 4,560        3,208              42%        12,980        9,418                 38%
More Personal Computing           3,627        3,154              15%        11,820        9,261                 28%


Total                        $   12,975$ 10,341              25%     $  39,552$ 30,554                 29%





Reportable Segments

Three Months Ended March 31, 2020 Compared with Three Months Ended March 31, 2019

Productivity and Business Processes

Revenue increased $1.5 billion or 15%.

• Office Commercial revenue increased $878 million or 13%, driven by Office

365 Commercial, offset in part by lower revenue from products licensed

on-premises, reflecting a continued shift to cloud offerings and a

slowdown in transactional licensing, primarily in small and medium

businesses. Office 365 Commercial revenue grew 25%, due to seat growth of

20% and higher revenue per user.



     •  Office Consumer revenue increased $160 million or 15%, driven by Office
        365 subscription revenue and strength in Office 2019, primarily in Japan.


     •  LinkedIn revenue increased $354 million or 21%, driven by growth across
        all businesses.


  • Dynamics revenue increased 17%, driven by Dynamics 365 growth of 47%.

Operating income increased $809 million or 20%.

• Gross margin increased $1.3 billion or 16%, driven by growth in Office

Commercial and LinkedIn. Gross margin percentage increased, due to gross

margin percentage improvement in Office 365 Commercial and LinkedIn,

offset in part by an increased mix of cloud offerings.

• Operating expenses increased $473 million or 12%, driven by investments in

LinkedIn and cloud engineering.

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

                                       36

--------------------------------------------------------------------------------
                                     PART I

                                     Item 2



Intelligent Cloud

Revenue increased $2.6 billion or 27%.

• Server products and cloud services revenue increased $2.4 billion or 30%,

driven by Azure. Azure revenue grew 59%, due to higher

infrastructure-as-a-service and platform-as-a-service consumption-based

services and per user-based services. Server products revenue increased

        11%, due to hybrid and premium solutions, as well as demand related to
        Windows Server 2008 end of support.

• Enterprise Services revenue increased $91 million or 6%, driven by growth

in Premier Support Services.

Operating income increased $1.4 billion or 42%.


     •  Gross margin increased $2.0 billion or 30%, 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 $625 million or 19%, driven by investments in

Azure.

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

More Personal Computing

Revenue increased $317 million or 3%.

• Windows revenue increased $276 million or 6%, driven by growth in Windows

Commercial. Windows Commercial revenue increased 17%, primarily driven by

increased demand for Microsoft 365. Windows OEM revenue was relatively

unchanged. Windows OEM Pro revenue grew 5%, driven by continued Windows 10

momentum, with demand from remote work and learn scenarios, offset in part

by supply chain constraints in China. Windows OEM non-Pro revenue

decreased 10%, driven by continued pressure in the entry-level category

and supply chain constraints in China.

• Search advertising revenue increased $75 million or 4%. Search advertising

revenue, excluding traffic acquisition costs, increased 1%, with reduced

        advertising spend, particularly in the industries most impacted by
        COVID-19.


     •  Surface revenue increased $11 million or 1%, driven by increased demand
        from remote work and learn scenarios, offset in part by supply chain
        constraints in China.


     •  Gaming revenue decreased $14 million or 1%. Xbox hardware revenue

decreased 20%, primarily due to a decrease in price of consoles sold. Xbox

content and services revenue increased $33 million or 2%, primarily due to

increased engagement following stay-at-home guidelines, offset in part by

        a high prior year comparable primarily from a third-party title.

Operating income increased $473 million or 15%.

• Gross margin increased $386 million or 6%, driven by growth in Windows.

        Gross margin percentage increased, due to sales mix shift to higher margin
        businesses.

• Operating expenses decreased $87 million or 3%, driven by the redeployment

of engineering resources.

Gross margin and operating income each included an unfavorable foreign currency impact of 2%.

Nine Months Ended March 31, 2020 Compared with Nine Months Ended March 31, 2019

Productivity and Business Processes

Revenue increased $4.5 billion or 15%.

• Office Commercial revenue increased $2.7 billion or 14%, driven by Office

365 Commercial, offset in part by lower revenue from products licensed

on-premises, reflecting a continued shift to cloud offerings. Office 365

        Commercial revenue grew 26%, due to seat growth and higher revenue per
        user.


     •  Office Consumer revenue increased $401 million or 13%, driven by Office
        365 subscription revenue and strength in Office 2019, primarily in Japan.


                                       37
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                                     PART I

                                     Item 2



     •  LinkedIn revenue increased $1.1 billion or 23%, driven by growth across
        all businesses.


  • Dynamics revenue increased 14%, driven by Dynamics 365 growth of 43%.

Operating income increased $2.9 billion or 24%.

• Gross margin increased $4.1 billion or 18%, driven by growth in Office

Commercial and LinkedIn. Gross margin percentage increased, due to gross

margin percentage improvement in Office 365 Commercial and LinkedIn,

offset in part by an increased mix of cloud offerings.

• Operating expenses increased $1.2 billion or 11%, driven by investments in

LinkedIn and cloud engineering.

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

Intelligent Cloud

Revenue increased $7.4 billion or 27%.

• Server products and cloud services revenue increased $6.9 billion or 30%,

driven by Azure. Azure revenue grew 60%, due to higher

infrastructure-as-a-service and platform-as-a-service consumption-based

services and per user-based services. Server products revenue increased

        11%, due to hybrid and premium solutions, as well as demand related
        to Windows Server 2008 and SQL Server 2008 end of support.

• Enterprise Services revenue increased $277 million or 6%, driven by growth

in Premier Support Services.

Operating income increased $3.6 billion or 38%.


     •  Gross margin increased $5.4 billion or 29%, 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 $1.8 billion or 19%, driven by investments in

Azure.

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

More Personal Computing

Revenue increased $922 million or 3%.

• Windows revenue increased $1.6 billion or 11%, driven by growth in Windows

Commercial and Windows OEM. Windows Commercial revenue increased 22%,

driven by increased demand for Microsoft 365. Windows OEM revenue

increased 9%, ahead of PC market growth. Windows OEM Pro revenue grew 16%,

        driven by continued momentum in advance of Windows 7 end of support and
        healthy Windows 10 demand. Windows OEM non-Pro revenue declined 4%, driven
        by continued pressure in the entry-level category.


     •  Search advertising revenue increased $465 million or 8%. Search
        advertising revenue, excluding traffic acquisition costs, increased 6%,
        driven by higher revenue per search.

• Surface revenue increased $83 million or 2%, driven by commercial growth,

offset in part by a decline in consumer.

• Gaming revenue decreased $1.1 billion or 12%, driven by a decrease in Xbox

hardware of 38%, primarily due to a decrease in volume and price of

consoles sold. Xbox content and services revenue decreased $269 million or

4%, against a high prior year comparable primarily from a third-party

title, offset in part by strength in Minecraft and growth in

subscriptions.

Operating income increased $2.6 billion or 28%, including an unfavorable foreign currency impact of 2%.

• Gross margin increased $2.1 billion or 12%, driven by growth in Windows.

        Gross margin percentage increased, due to sales mix shift to higher margin
        businesses.


     •  Operating expenses decreased $421 million or 5%, driven by the

redeployment of engineering resources, offset in part by investments in

        Gaming.


                                       38
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                                     Item 2



                               OPERATING EXPENSES

Research and Development



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


                                   2020          2019                          2020         2019

Research and development     $    4,887$  4,316             13%     $  14,055$ 12,363             14%
As a percent of revenue             14%           14%            0ppt           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 March 31, 2020 Compared with Three Months Ended March 31, 2019

Research and development expenses increased $571 million or 13%, driven by investments in cloud engineering and LinkedIn.

Nine Months Ended March 31, 2020 Compared with Nine Months Ended March 31, 2019

Research and development expenses increased $1.7 billion or 14%, driven by investments in cloud engineering, LinkedIn, and Gaming.

Sales and Marketing



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


                                   2020          2019                           2020         2019

Sales and marketing          $    4,911$  4,565               8%     $  14,181$ 13,251              7%
As a percent of revenue             14%           15%           (1)ppt           14%          14%            0ppt





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

Three Months Ended March 31, 2020 Compared with Three Months Ended March 31, 2019

Sales and marketing expenses increased $346 million or 8%, driven by investments in LinkedIn and commercial sales, as well as an increase in bad debt expense.

Nine Months Ended March 31, 2020 Compared with Nine Months Ended March 31, 2019

Sales and marketing expenses increased $930 million or 7%, driven by investments in LinkedIn and commercial sales.


General and Administrative



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


                                  2020          2019                           2020         2019

General and
administrative              $    1,273$  1,179              8%     $    3,455$  3,460               0%
As a percent of revenue             4%            4%            0ppt             3%           4%           (1)ppt





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                                     PART I

                                     Item 2



General and administrative expenses include payroll, employee benefits,
stock-based compensation expense, severance expense, and other headcount-related
expenses associated with finance, legal, facilities, certain human resources and
other administrative personnel, certain taxes, and legal and other
administrative fees.

Three Months Ended March 31, 2020 Compared with Three Months Ended March 31, 2019

General and administrative expenses increased $94 million or 8%.

Nine Months Ended March 31, 2020 Compared with Nine Months Ended March 31, 2019

General and administrative expenses were relatively unchanged.

                          OTHER INCOME (EXPENSE), NET

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



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


                                                 2020             2019           2020          2019

Interest and dividends income              $      673$      668$    2,085$   2,053
Interest expense                                 (614 )           (671 )       (1,905 )      (2,017 )
Net recognized gains (losses) on
investments                                      (101 )             44              4           381
Net gains on derivatives                           49               51            136            89
Net gains (losses) on foreign currency
remeasurements                                   (136 )             37           (218 )         (32 )
Other, net                                         (3 )             16            (40 )          64


Total                                      $     (132 )$      145$       62$     538

We use derivative instruments to: manage risks related to foreign currencies, equity prices, interest rates, and credit; enhance investment returns; and facilitate portfolio diversification. Gains and losses from changes in fair values of derivatives that are not designated as hedging instruments are primarily recognized in other income (expense), net.

Three Months Ended March 31, 2020 Compared with Three Months Ended March 31, 2019


Interest and dividends income increased due to higher average portfolio balances
on fixed-income securities. Interest expense decreased due to capitalization of
interest expense and a decrease in outstanding long-term debt due to debt
maturities, offset in part by higher finance lease expense. Net recognized
losses on investments include other-than-temporary impairments and losses on
equity securities in the current period as compared to net recognized gains on
investments in the prior period.

Nine Months Ended March 31, 2020 Compared with Nine Months Ended March 31, 2019


Interest and dividends income increased due to higher average portfolio balances
on fixed-income securities. Interest expense decreased due to capitalization of
interest expense and a decrease in outstanding long-term debt due to debt
maturities, offset in part by higher finance lease expense. Net recognized gains
on investments decreased due to lower gains and higher other-than-temporary
impairments on equity investments, offset in part by gains on fixed income
securities in the current period compared to losses in the prior period. Net
gains on derivatives increased due to higher gains on foreign exchange and
interest rate derivatives.

                                  INCOME TAXES

Effective Tax Rate

Our effective tax rate was 16% for the three months ended March 31, 2020 and
2019, and 16% for the nine months ended March 31, 2020 and 2019. The effective
tax rate was relatively unchanged for the three months ended March 31, 2020
compared to the prior year, primarily due to changes in the mix of our income
before income taxes between the U.S. and foreign countries, offset in part by
tax benefits relating to stock-based compensation. The effective tax rate was
relatively unchanged for the nine months ended March 31, 2020 compared to the
prior year, primarily due to changes in the mix of our income before income
taxes between the U.S. and foreign countries, offset in part by the adjustment
of the provisional net charge related to the TCJA in the second quarter of
fiscal year 2019.

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                                     Item 2



Our effective tax rate was lower than the U.S. federal statutory rate for the
three and nine months ended March 31, 2020, primarily due to earnings taxed at
lower rates in foreign jurisdictions resulting from producing and distributing
our products and services through our foreign regional operations centers in
Ireland and Puerto Rico, and tax benefits relating to stock-based compensation.

Uncertain Tax Positions


We settled a portion of the Internal Revenue Service ("IRS") audit for tax years
2004 to 2006 in fiscal year 2011. In February 2012, the IRS withdrew its 2011
Revenue Agents Report related to unresolved issues for tax years 2004 to 2006
and reopened the audit phase of the examination. We also settled a portion of
the IRS audit for tax years 2007 to 2009 in fiscal year 2016, and a portion of
the IRS audit for tax years 2010 to 2013 in fiscal year 2018. We remain under
audit for tax years 2004 to 2013. We expect the IRS to begin an examination of
tax years 2014 to 2017 within the next 12 months.

As of March 31, 2020, the primary unresolved issues for the IRS audits relate to
transfer pricing, which could have a material impact in our consolidated
financial statements when the matters are resolved. We believe our allowances
for income tax contingencies are adequate. We have not received a proposed
assessment for the unresolved issues and do not expect a final resolution of
these issues in the next 12 months. Based on the information currently
available, we do not anticipate a significant increase or decrease to our tax
contingencies for these issues within the next 12 months.

We are subject to income tax in many jurisdictions outside the U.S. Our
operations in certain jurisdictions remain subject to examination for tax years
1996 to 2019, some of which are currently under audit by local tax authorities.
The resolution of each of these audits is not expected to be material to our
consolidated financial statements.

                          NON-GAAP FINANCIAL MEASURES

Non-GAAP net income and diluted earnings per share are non-GAAP financial measures which exclude a net charge related to the TCJA. We believe these non-GAAP measures aid investors by providing additional insight into our operational performance and help clarify trends affecting our business. For comparability of reporting, management considers non-GAAP measures in conjunction with GAAP financial results in evaluating business performance. These non-GAAP financial measures presented should not be considered a substitute for, or superior to, the measures of financial performance prepared in accordance with GAAP.

The following table reconciles our financial results reported in accordance with GAAP to non-GAAP financial results:




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


                                                        2020           2019                             2020           2019

Net income                                       $    10,752$    8,809              22%     $    33,079$   26,053              27%
Net charge related to the TCJA                             0              0                *               0            157                *


Non-GAAP net income                              $    10,752$    8,809              22%     $    33,079$   26,210              26%


Diluted earnings per share                       $      1.40$     1.14              23%     $      4.30$     3.36              28%
Net charge related to the TCJA                             0              0                *               0           0.02                *


Non-GAAP diluted earnings per share              $      1.40$     1.14              23%     $      4.30$     3.38              27%






* Not meaningful.




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                                     Item 2



                              FINANCIAL CONDITION

Cash, Cash Equivalents, and Investments


Cash, cash equivalents, and short-term investments totaled $137.6 billion and
$133.8 billion as of March 31, 2020 and June 30, 2019. Equity investments were
$2.7 billion and $2.6 billion as of March 31, 2020 and June 30, 2019,
respectively. Our short-term investments are primarily intended to facilitate
liquidity and capital preservation. They consist predominantly of highly liquid
investment-grade fixed-income securities, diversified among industries and
individual issuers. The investments are 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 without applying significant adjustments. In addition, all our
broker-priced investments have a sufficient level of trading volume to
demonstrate that the fair values used are appropriate for these investments. Our
fair value processes include controls that are designed to ensure appropriate
fair values are recorded. These controls include model validation, review of key
model inputs, analysis of period-over-period fluctuations, and independent
recalculation of prices where appropriate.

Cash Flows


Cash from operations increased $5.9 billion to $42.0 billion for the nine months
ended March 31, 2020, mainly due to an increase in cash from customers, offset
in part by an increase in cash used to pay income taxes, suppliers, and
employees. Cash used in financing increased $5.6 billion to $33.8 billion for
the nine months ended March 31, 2020, mainly due to a $2.5 billion increase in
repayments of debt, a $2.3 billion increase in common stock repurchases, and a
$982 million increase in dividends paid. Cash used in investing decreased $755
million to $7.8 billion for the nine months ended March 31, 2020, mainly due to
a $1.2 billion decrease in cash used for acquisition of companies, net of cash
acquired, and purchases of intangible and other assets, offset in part by an
$823 million increase in additions to property and equipment.

Debt


We issue debt to take advantage of favorable pricing and liquidity in the debt
markets, reflecting our credit rating and the low interest rate environment. The
proceeds of these issuances were or will be used for general corporate purposes,
which may include, among other things, funding for working capital, capital
expenditures, repurchases of capital stock, acquisitions, and repayment of
existing debt. Our last debt issuance occurred in fiscal year 2017. Refer to
Note 9 - Debt of the Notes to Financial Statements (Part I, Item 1 of this Form
10-Q) for further discussion.

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                                     Item 2



Unearned Revenue

Unearned revenue comprises mainly unearned revenue related to volume licensing
programs, which may include Software Assurance ("SA") and cloud services.
Unearned revenue is generally invoiced annually at the beginning of each
contract period for multi-year agreements and recognized ratably over the
coverage period. Unearned revenue also includes payments for other offerings for
which we have been paid in advance and earn the revenue when we transfer control
of the product or service.

The following table outlines the expected future recognition of unearned revenue as of March 31, 2020:



(In millions)


Three Months Ending

June 30, 2020$ 12,528
September 30, 2020       7,017
December 31, 2020        5,252
March 31, 2021           2,215
Thereafter               3,385


Total                 $ 30,397

If our customers choose to license cloud-based versions of our products and services rather than licensing transaction-based products and services, the associated revenue will shift from being recognized at the time of the transaction to being recognized over the subscription period or upon consumption, as applicable.

Share Repurchases


For the nine months ended March 31, 2020 and 2019, we repurchased 98 million
shares and 117 million shares of our common stock for $14.6 billion and $12.6
billion, respectively, through our share repurchase programs. All repurchases
were made using cash resources. Refer to Note 14 - Stockholders' Equity of the
Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further
discussion.

Dividends

Refer to Note 14 - Stockholders' Equity of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion.

Off-Balance Sheet Arrangements


We provide indemnifications of varying scope and size to certain customers
against claims of intellectual property infringement made by third parties
arising from the use of our products and certain other matters. Additionally, we
have agreed to cover damages resulting from breaches of certain security and
privacy commitments in our cloud business. In evaluating estimated losses on
these obligations, we consider factors such as the degree of probability of an
unfavorable outcome and our ability to make a reasonable estimate of the amount
of loss. These obligations did not have a material impact in our consolidated
financial statements during the periods presented.

Other Planned Uses of Capital


We will continue to invest in sales, marketing, product support infrastructure,
and existing and advanced areas of technology, as well as continue making
acquisitions that align with our business strategy. Additions to property and
equipment will continue, including new facilities, datacenters, and computer
systems for research and development, sales and marketing, support, and
administrative staff. We expect capital expenditures to increase in coming years
to support growth in our cloud offerings. We have operating and finance leases
for datacenters, corporate offices, research and development facilities, retail
stores, and certain equipment. We have not engaged in any related party
transactions or arrangements with unconsolidated entities or other persons that
are reasonably likely to materially affect liquidity or the availability of
capital resources.

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                                     Item 2



Liquidity

As a result of the TCJA, we are required to pay a one-time transition tax on
deferred foreign income not previously subject to U.S. income tax. Under the
TCJA, the transition tax is payable in interest-free installments over eight
years, with 8% due in each of the first five years, 15% in year six, 20% in year
seven, and 25% in year eight. We have paid transition tax of $3.2 billion, which
included $1.2 billion during the nine months ended March 31, 2020. The remaining
transition tax of $15.2 billion is payable over the next six years with a final
payment in fiscal year 2026. During the nine months ended March 31, 2020, we
also paid $3.7 billion related to the transfer of intangible properties that
occurred in the fourth quarter of fiscal year 2019.

We expect existing cash, cash equivalents, short-term investments, cash flows
from operations, and access to capital markets to continue to be sufficient to
fund our operating activities and cash commitments for investing and financing
activities, such as dividends, share repurchases, debt maturities, material
capital expenditures, and the transition tax related to the TCJA, for at least
the next 12 months and thereafter for the foreseeable future.

                           RECENT ACCOUNTING GUIDANCE

Refer to Note 1 - Accounting Policies of the Notes to Financial Statements (Part I, Item 1 of this Form 10-Q) for further discussion.

                  APPLICATION OF CRITICAL ACCOUNTING POLICIES

Our consolidated financial statements and accompanying notes are prepared in
accordance with GAAP. Preparing consolidated financial statements requires
management to make estimates and assumptions that affect the reported amounts of
assets, liabilities, revenue, and expenses. These estimates and assumptions are
affected by management's application of accounting policies, as well as
uncertainty in the current economic environment due to the recent outbreak of
COVID-19. Critical accounting policies for us include revenue recognition,
impairment of investment securities, goodwill, research and development costs,
contingencies, income taxes, and inventories.

Revenue Recognition


Our contracts with customers often include promises to transfer multiple
products and services to a customer. Determining whether products and services
are considered distinct performance obligations that should be accounted for
separately versus together may require significant judgment. When a cloud-based
service includes both on-premises software licenses and cloud services, judgment
is required to determine whether the software license is considered distinct and
accounted for separately, or not distinct and accounted for together with the
cloud service and recognized over time. Certain cloud services, primarily Office
365, depend on a significant level of integration, interdependency, and
interrelation between the desktop applications and cloud services, and are
accounted for together as one performance obligation. Revenue from Office 365 is
recognized ratably over the period in which the cloud services are provided.

Judgment is required to determine the stand-alone selling price ("SSP") for each
distinct performance obligation. We use a single amount to estimate SSP for
items that are not sold separately, including on-premises licenses sold with SA
or software updates provided at no additional charge. We use a range of amounts
to estimate SSP when we sell each of the products and services separately and
need to determine whether there is a discount to be allocated based on the
relative SSP of the various products and services.

In instances where SSP is not directly observable, such as when we do not sell
the product or service separately, we determine the SSP using information that
may include market conditions and other observable inputs. We typically have
more than one SSP for individual products and services due to the stratification
of those products and services by customers and circumstances. In these
instances, we may use information such as the size of the customer and
geographic region in determining the SSP.



Due to the various benefits from and the nature of our SA program, judgment is
required to assess the pattern of delivery, including the exercise pattern of
certain benefits across our portfolio of customers.

                                       44

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                                     PART I

                                     Item 2



Our products are generally sold with a right of return, we may provide other
credits or incentives, and in certain instances we estimate customer usage of
our products and services, which are accounted for as variable consideration
when determining the amount of revenue to recognize. Returns and credits are
estimated at contract inception and updated at the end of each reporting period
if additional information becomes available. Changes to our estimated variable
consideration were not material for the periods presented.

Impairment of Investment Securities


We review debt investments quarterly for indicators of other-than-temporary
impairment. This determination requires significant judgment. In making this
judgment, we employ a systematic methodology quarterly that considers available
quantitative and qualitative evidence in evaluating potential impairment of our
investments. If the cost of an investment exceeds its fair value, we evaluate,
among other factors, general market conditions, credit quality of debt
instrument issuers, and the duration and extent to which the fair value is less
than cost. We also evaluate whether we have plans to sell the security or it is
more likely than not that we will be required to sell the security before
recovery. In addition, we consider specific adverse conditions related to the
financial health of and business outlook for the investee, including industry
and sector performance, changes in technology, and operational and financing
cash flow factors. Once a decline in fair value is determined to be
other-than-temporary, an impairment charge is recorded in other income
(expense), net and a new cost basis in the investment is established. If market,
industry, and/or investee conditions deteriorate, we may incur future
impairments.

Equity investments without readily determinable fair values are written down to
fair value if a qualitative assessment indicates that the investment is impaired
and the fair value of the investment is less than carrying value. We perform a
qualitative assessment on a quarterly basis. We are required to estimate the
fair value of the investment to determine the amount of the impairment loss.
Once an investment is determined to be impaired, an impairment charge is
recorded in other income (expense), net.

Goodwill


We allocate goodwill to reporting units based on the reporting unit expected to
benefit from the business combination. We evaluate our reporting units on an
annual basis and, if necessary, reassign goodwill using a relative fair value
allocation approach. Goodwill is tested for impairment at the reporting unit
level (operating segment or one level below an operating segment) on an annual
basis (May 1 for us) and between annual tests if an event occurs or
circumstances change that would more likely than not reduce the fair value of a
reporting unit below its carrying value. These events or circumstances could
include a significant change in the business climate, legal factors, operating
performance indicators, competition, or sale or disposition of a significant
portion of a reporting unit.

Application of the goodwill impairment test requires judgment, including the
identification of reporting units, assignment of assets and liabilities to
reporting units, assignment of goodwill to reporting units, and determination of
the fair value of each reporting unit. The fair value of each reporting unit is
estimated primarily through the use of a discounted cash flow methodology. This
analysis requires significant judgments, including estimation of future cash
flows, which is dependent on internal forecasts, estimation of the long-term
rate of growth for our business, estimation of the useful life over which cash
flows will occur, and determination of our weighted average cost of capital.

The estimates used to calculate the fair value of a reporting unit change from
year to year based on operating results, market conditions, and other factors.
Changes in these estimates and assumptions could materially affect the
determination of fair value and goodwill impairment for each reporting unit.

Research and Development Costs


Costs incurred internally in researching and developing a computer software
product are charged to expense until technological feasibility has been
established for the product. Once technological feasibility is established,
software costs are capitalized until the product is available for general
release to customers. Judgment is required in determining when technological
feasibility of a product is established. We have determined that technological
feasibility for our software products is reached after all high-risk development
issues have been resolved through coding and testing. Generally, this occurs
shortly before the products are released to production. The amortization of
these costs is included in cost of revenue over the estimated life of the
products.

                                       45

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                                     PART I

                                     Item 2



Legal and Other Contingencies

The outcomes of legal proceedings and claims brought against us are subject to
significant uncertainty. An estimated loss from a loss contingency such as a
legal proceeding or claim is accrued by a charge to income if it is probable
that an asset has been impaired or a liability has been incurred and the amount
of the loss can be reasonably estimated. In determining whether a loss should be
accrued we evaluate, among other factors, the degree of probability of an
unfavorable outcome and the ability to make a reasonable estimate of the amount
of loss. Changes in these factors could materially impact our consolidated
financial statements.

Income Taxes


The objectives of accounting for income taxes are to recognize the amount of
taxes payable or refundable for the current year, and deferred tax liabilities
and assets for the future tax consequences of events that have been recognized
in an entity's financial statements or tax returns. We recognize the tax benefit
from an uncertain tax position only if it is more likely than not that the tax
position will be sustained on examination by the taxing authorities, based on
the technical merits of the position. The tax benefits recognized in the
financial statements from such a position are measured based on the largest
benefit that has a greater than 50% likelihood of being realized upon ultimate
settlement. Accounting literature also provides guidance on derecognition of
income tax assets and liabilities, classification of deferred income tax assets
and liabilities, accounting for interest and penalties associated with tax
positions, and income tax disclosures. Judgment is required in assessing the
future tax consequences of events that have been recognized in our consolidated
financial statements or tax returns. Variations in the actual outcome of these
future tax consequences could materially impact our consolidated financial
statements.

Inventories


Inventories are stated at average cost, subject to the lower of cost or net
realizable value. Cost includes materials, labor, and manufacturing overhead
related to the purchase and production of inventories. Net realizable value is
the estimated selling price less estimated costs of completion, disposal, and
transportation. We regularly review inventory quantities on hand, future
purchase commitments with our suppliers, and the estimated utility of our
inventory. These reviews include analysis of demand forecasts, product life
cycle status, product development plans, current sales levels, pricing strategy,
and component cost trends. If our review indicates a reduction in utility below
carrying value, we reduce our inventory to a new cost basis through a charge to
cost of revenue.





                                       46
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                                     PART I

                                   Item 3, 4

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