Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations  
Management’s Discussion and Analysis (MD&A) contains statements that are forward-looking. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in “Issues and Uncertainties” in this item and elsewhere in this report.

OVERVIEW  
The following Management’s Discussion and Analysis 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 financial statements and the accompanying notes (Notes). The revenue and operating income (loss) amounts in this MD&A are presented in accordance with U.S. GAAP. Segment information appearing in Note 9 of the Notes to Financial Statements are presented in accordance with SFAS 131, Disclosures about Segments of an Enterprise and Related Information.  
We develop, manufacture, license, and support a wide range of software products for many computing devices. Our software products include operating systems for servers, personal computers (PCs), and intelligent devices; server applications for distributed computing environments; information worker productivity applications; business solutions applications; and software development tools. We provide consulting and product support services, and we train and certify system integrators and developers. We sell the Xbox video game console and games, PC games, and peripherals. Online communication tools and information offerings are delivered through our MSN portals and channels around the world.  
Our revenue historically has fluctuated quarterly and has generally been the highest in the second quarter of our fiscal year, due to corporate calendar year-end spending trends in our major markets and holiday season spending by consumers. Our Home and Entertainment segment is particularly subject to seasonality as its products are aimed at the consumer market and are in highest demand during the holiday shopping season. Historically, approximately 40% to 50% of Home and Entertainment revenue has been generated in the second fiscal quarter. We believe that the seasonality of revenue is likely to continue in the future.  
We intend to sustain the long-term growth of our businesses through technological innovation, engineering excellence, and a commitment to delivering high-quality products and services to customers and partners. Recognizing that one of our primary challenges is to help accelerate worldwide PC adoption and software upgrades, we continue to advance the functionality, security and value of Windows operating systems, including versions for new devices such as Tablet PCs, Media Center PCs, Portable Media Centers, and mobile devices such as Smartphones. We also develop innovative software applications and solutions to enhance the productivity of information workers, improve communication and collaboration in work groups, and streamline processes for small and mid-sized businesses. To sustain the growth of our Server and Tools business amid competition from other vendors of both proprietary and open source software, our goal is to deliver products that provide the best platform for network computing—the most advanced, easiest to deploy and manage and most secure—with the lowest total cost of ownership. To take advantage of new market opportunities, we continue to invest in research and development of existing and new lines of business, such as search services, that we believe can contribute significantly to our long-term growth.  

Summary
Our revenue increase for the three and six months ended December 31, 2004 was primarily driven by growth in licensing of Windows Server operating systems and other server applications, and Windows Client operating systems through OEMs (original equipment manufacturers), as a result of growth in server hardware and PC shipments, overall improvements in information technology (IT) spending, and fluctuations in foreign currency exchange rates. The November launch of the Halo 2 Xbox game for the holiday season also contributed to the overall revenue growth for the company in the second quarter of fiscal 2005. Revenue growth rates in the second quarter of fiscal 2005 were lower because of launch-related Office 2003 revenue in fiscal 2004 and a $289 million and $630 million decline in earned revenue from Upgrade Advantage for the three and six months period ended December 31, 2004, respectively. The reduction in Upgrade Advantage revenue has been partially offset by customers entering into other licensing agreements.  
We estimate growth in PC shipments was 12% during the second quarter of fiscal 2005 compared to the same period in fiscal 2004. We estimate that total server hardware shipments grew 15%, with Windows Server shipments growing faster than the overall sector at 19% in the second quarter of fiscal 2005. The net impact of foreign exchange rates on revenue was positive in the three and six month periods ended December 31, 2004, primarily due to relative strengthening of most foreign currencies particularly the Euro and Japanese yen, against the U.S. dollar. Had the exchange rates from the prior year been in effect, translated international revenue growth earned in local currencies would have been approximately $253 million or two percentage points lower for the second quarter of fiscal 2005 and $474 million or three percentage points lower for the first six months of fiscal 2005. Fluctuations in foreign currency exchange rates have a greater impact on non-OEM commercial and retail license business as a significant percentage of those product revenues are denominated in foreign currencies. The vast majority of OEM license revenue is denominated in U.S. dollars. We hedge a portion of our international currency exposures, thereby reducing our overall translation exposure.  
For the three and six months ended December 31, 2004, the operating income increases were primarily driven by a significant decline in stock-based compensation expense primarily related to the stock option transfer program completed in the second quarter of fiscal 2004, combined with the increased revenue in Server and Tools and Client, which have higher gross margins as compared with other segments. Additionally, strong sales of Halo 2 drove the Home and Entertainment segment to profitability in the second quarter of fiscal 2005. The decrease in stock-based compensation expense of $2.68 billion and $2.95 billion in the second quarter and first six months of fiscal 2005 respectively was partially offset by increased operating expenses of $136 million in the second quarter and $314 million in the first six months of fiscal 2005, related to increased salary and benefits for new and existing headcount. The decrease in stock-based compensation was also partially offset by an increase in legal costs, primarily related to the $536 million Novell settlement recorded in the quarter ended September 30, 2004.  

In fiscal 2004, we implemented changes in employee compensation whereby employees are granted stock awards rather than stock options. We also completed an employee stock option transfer program in the second quarter of fiscal 2004 in which employees could elect to transfer all of their vested and unvested stock options with a strike price of $33 or higher to JPMorgan. The unvested options that were transferred to JPMorgan became vested upon the transfer. A total of 344.6 million of the 621.4 million eligible options were transferred, which resulted in additional stock-based compensation expense of $2.21 billion in the second quarter of fiscal 2004. As a result of these changes, we expect stock-based compensation to continue to decrease in future quarters. Based on actual experience, during the second quarter of fiscal 2005 we revised our estimated option forfeiture rates resulting in a decrease to stock-based compensation expense of $167 million.  
The following table shows total stock-based compensation expense for the three and six months ended December 31, 2004 and the comparable prior year periods.

We estimate PC shipments will grow 9% to 11% and Server unit shipments will grow 13% to 15% in fiscal 2005 compared to fiscal 2004. These growth rates are lower than fiscal 2004. We will likely experience favorable exchange rate impacts in the third quarter of fiscal 2005 due to stronger foreign currencies compared to the U.S. dollar versus a year ago. We expect our operating income to continue to grow faster than revenue in fiscal 2005. Operating income is expected to reflect lower operating expenses mainly due to continued lower stock-based compensation expense and savings achieved through continued progress in our cost efficacy initiative.

SEGMENT PRODUCT REVENUE/OPERATING INCOME (LOSS)
Our seven segments are: Client; Server and Tools; Information Worker; Microsoft Business Solutions; MSN; Mobile and Embedded Devices; and Home and Entertainment.
The revenue and operating income/(loss) amounts in this section are presented on a basis consistent with U.S. GAAP applied at the segment level. Fiscal 2004 segment information has been restated for reclassifications due to internal reorganizations and to conform to the current period presentation including reclassifying certain legal settlements. Certain corporate level expenses have been excluded. Those expenses primarily include corporate operations related to sales and marketing, product support services, human resources, legal, finance, IT, corporate development and procurement activities, research and development costs, and accrued legal contingencies. Corporate expenses were $1.50 billion and $901 million in the three months ended December 31, 2003 and 2004, respectively. Corporate expenses were $2.28 billion and $2.26 billion in the six months ended December 31, 2003 and 2004, respectively. The decrease in corporate expenses was due to a decrease in stock-based compensation expense partially offset by an increase in legal costs primarily associated with the $536 million Novell settlement recorded in the first quarter of fiscal 2005.

Client 
Client includes revenue from Windows XP Professional and Home, Media Center Edition, Tablet PC Edition, and other standard Windows operating systems. Client revenue growth is correlated with the growth of purchases of PCs from OEMs that pre-install versions of Windows operating systems because the OEM channel accounts for over 80% of total Client revenue. The operating results for the three and six months ended December 31, 2003 have been restated to reflect the reorganization of the Windows Security group from Server and Tools to Client.  
Client revenue increase for the second quarter was driven by a 12% growth in OEM licenses and $257 million or 10% growth in OEM revenue from increased PC unit shipments partially offset by a $96 million or 16% decrease in revenue from commercial and retail licensing of Windows operating systems. The difference between OEM unit growth and revenue growth was partially attributable to the deferral rates and product lives for undelivered elements of unearned revenue. The mix of Windows operating systems licensed during the quarter with premium edition operating systems as a percentage of total Client operating systems licensed during the quarter decreased by one percentage point to 54% of total Client operating systems compared to the second quarter of the prior fiscal year due to a decline in commercial and retail licensing of premium Client operating systems. Client revenue increased for the six months ended December 31, 2004 reflecting Windows OEM license unit growth of 11%, which drove a $404 million or 9% growth in OEM revenue compared to the corresponding period in the prior year, which was partially offset by a $58 million or 5% decline in commercial and retail licensing revenue. The mix of Windows operating systems licensed during the first half of the fiscal year with premium edition operating systems as a percentage of total Client operating systems licensed during the same period decreased one percentage point to 57% of total Client operating system as compared to the first six months of the prior fiscal year due to a decline in commercial and retail licensing of premium Client operating systems.  
Client operating income increase for the three and six months ended December 31, 2004 was primarily due to a decrease in stock-based compensation expense and an increase in OEM revenue. These impacts were partially offset by an increase in operating expenses associated with the continued development of the Windows Client next generation operating system (Longhorn). The operating income for the three and six months ended December 31, 2003 has been restated for a reclassification of legal settlements from Client to corporate expenses to conform to the current year presentation.  
We plan to continue our efforts to increase premium product mix and anticipate that continued PC market growth will result in revenue growth for the remainder of fiscal 2005. We expect these factors to be partially offset by the decrease in revenue earned from Upgrade Advantage licensing agreements. We expect that our Enterprise Agreement (EA) contracts that expire in fiscal 2005 will be partially offset by renewals and new EA contracts. As a result, Client commercial and retail licensing revenue is expected to continue to lag behind overall Client revenue growth.

Server and Tools 
Server and Tools consists of server software licenses and client access licenses (CALs) for Windows Server, SQL Server, Exchange Server, and other server products. It also includes developer tools, training, certification, Microsoft Press, Premier and Professional product support services, and Microsoft Consulting Services. The Server and Tools segment concentrates on licensing products, applications, tools, content, and services that make information technology professionals and developers more productive and efficient. The segment uses multiple channels for licensing including pre-installed OEM versions, licenses through partners, and licenses directly to end customers. The licenses are sold both as one-time licenses and as multi-year volume licenses depending upon the needs of different customer segments. The Server and Tools segment uses product innovation and partnerships with information technology professionals to drive the adoption and sales growth of its products. Server and Tools growth is driven by performance of the overall market for information technology, both hardware and software. The operating results for the first six months of fiscal 2004 have been restated for the reorganization of the Windows Security group from Server and Tools to Client and the reorganization of Professional product support services from Information Worker to Server and Tools.  
Server and Tools revenue increase in the second quarter of fiscal 2005 was driven by a 17% growth in new Windows Server license units and growth in SQL Server, Exchange Server and Core CAL revenue. We estimate that Windows-based server shipments grew 19% in the second quarter of fiscal 2005 compared to the prior year, and that this growth rate was two to four percentage points higher than growth in the overall server hardware market. Server and Server applications revenue, including CAL revenue, grew $328 million or 20% in the second quarter of fiscal 2005 as compared with the corresponding period in fiscal 2004. Consulting and Premier and Professional product support services revenue increased $54 million or 17% compared to the prior year, primarily due to increased consultant utilization and new Premier customers. Foreign exchange rate changes accounted for approximately $78 million or four percentage points of total Server and Tools revenue growth, which was offset by an $87 million decline in Upgrade Advantage revenue earned. In the first six months of fiscal 2005, we estimate that overall server hardware shipments grew 15% compared to the prior year. Server and Tools revenue increase for the first six months of fiscal 2005 was driven by an estimated 19% increase in Windows-based server shipments resulting in 17% growth in new Windows Server license units and growth in SQL Server, Exchange Server and Core CAL revenue. In the first six months of fiscal 2005, Server and Server applications revenue, including CAL revenue, grew $616 million or 20% compared with the corresponding period in fiscal 2004. Consulting and Premier and Professional product support services revenue increased $118 million or 20% in the first six months of fiscal 2005 compared to the prior year, primarily due to increased consultant utilization and new Premier customers. Foreign exchange rate changes accounted for approximately $149 million or four percentage points of total Server and Tools revenue growth for the first six months of fiscal 2005, which was offset by a $184 million decline in Upgrade Advantage revenue earned.  
Server and Tools operating income growth for the three and six months ended December 31, 2004 was primarily due to a decrease in stock-based compensation expense and the increase in revenue. This was partially offset by an increase in sales and marketing costs and headcount-related costs from increased hiring and increases in salary and benefits.  
We expect overall server hardware shipments to grow 13% to 15% in fiscal 2005. During the first six months of fiscal 2005, new Windows-based server shipments grew faster than the overall market and we expect this trend to continue during the remainder of fiscal 2005. However, we face strong competition from Linux-based, Unix, and other server operating systems. In addition, Server and Tools net revenue for fiscal 2005 will be unfavorably affected by the decline of revenue from our Upgrade Advantage program, which we expect will be partially offset by an increase in other multi-year volume licensing business. We will likely experience favorable exchange rate impacts in the third quarter of fiscal 2005 due to stronger foreign currencies compared to the U.S. dollar versus a year ago. We also expect Server and Tools operating expenses to increase during the remainder of fiscal 2005 due to expected investment in headcount and new marketing initiatives and upcoming product releases, including SQL Server 2005 and Visual Studio 2005.

Home and Entertainment 
Home and Entertainment includes the Microsoft Xbox video game console system, PC games, the Home Products Division (HPD), and TV platform products for the interactive television industry. The success of video game consoles is determined by console functionality, the portfolio of video game content for the console, and the market share of the console. Revenue and unit volumes have grown quickly since we entered the market in 2002 and we have established ourselves as one of the market leaders. However, revenue growth moderated in fiscal 2004 due to price reductions typical at this later stage in the console lifecycle. We believe our competitive position and revenue is bolstered by our increasing software game attach rates, which provides higher margins to offset the declining prices on consoles sold. Xbox consoles have negative gross margins.
Home and Entertainment revenue increased in the second quarter primarily due to significant new product launches. In the second quarter of fiscal 2005, Xbox revenue increased $180 million or 20% mainly due to the introduction of Halo 2, which generated approximately $300 million in revenue. This was partially offset by a decline in Xbox consoles revenue resulting from price reductions in the third quarter of fiscal 2004 accompanied by flat Xbox consoles volume. The Xbox life-to-date U.S. games attach rate increased to 7.7 games per console according to industry analyst NPD as of December 31, 2004. Revenue from consumer hardware and software, PC games, and TV platforms declined $40 million or 11% compared to fiscal 2004 due to lower PC games software sales. For the six months ended December 31, 2004, Home and Entertainment revenue increased mainly because of an increase in Xbox revenue of $251 million or 21% due to strong product launches, partially offset by a $60 million or 10% decline related to consumer hardware and software, PC games, and TV platforms.  
Home and Entertainment was profitable in the second quarter of fiscal 2005 due to an increase in revenue driven by the launch of Halo 2 and a decrease in stock-based compensation expense. These same factors helped reduce the operating loss in the six months ended December 31, 2004. The improvement in profitability was partially offset by an increase in costs associated with the next generation console development efforts. Operating expenses continue to be driven by investment in the next generation Xbox platform design, sales and marketing efforts directed towards new game title promotions, and other headcount-related costs.  
We continue to expect annual Xbox consoles revenue to decrease from fiscal 2004 consistent with this stage of the Xbox console lifecycle, offset by increased software unit volumes primarily driven by the launch of software titles such as Halo 2. In fiscal 2005 we expect PC games revenue to decrease from fiscal 2004 as we are releasing fewer new game titles. We expect operating margins to improve from fiscal 2004 driven by increased sales of high margin software. We continue to expect product development costs to increase, primarily due to the planned next generation console.

Information Worker 
Information Worker consists of the Microsoft Office System of programs, servers, services, and solutions designed to increase personal, team, and organization productivity. Information Worker includes Microsoft Office, Microsoft Project, Microsoft Visio, SharePoint Portal Server CALs, and other information worker products including Microsoft LiveMeeting and OneNote. Most revenue from this segment comes from licensing our Office System products. Revenue growth depends on the ability to add value to the core Office product set and expand our product offerings in other information worker areas such as document lifecycle and collaboration. As announced in the fourth quarter of fiscal 2004, the Small and Mid-Market Solutions & Partners (SMS&P) organization, which was historically part of the Information Worker segment, was re-aligned in the Microsoft Business Solutions segment. As a result of this change, Information Worker segment information has been restated to reflect the reclassification of the SMS&P organization to Microsoft Business Solutions. The results for the three and six months ended December 31, 2003 have also been restated due to the reclassification of product support services from Information Worker into Server and Tools.  
Information Worker revenue decreased in the second quarter primarily due to the favorable impact of the launch of Office 2003 in the comparable period of the prior year. That impact included recognition of $137 million of Office 2003 revenue that had been deferred from the first quarter of fiscal 2004 related to product upgrade rights provided to the customers who purchased Office XP just prior to the launch. We experienced a decline of 4% or $104 million in retail and commercial licensing. Strength in OEM pre-installed copies of Office sold through the system builder channel continued, resulting in a 5% or $18 million growth in revenue in the OEM channel. Upgrade Advantage earned revenue declined by $175 million during the second quarter and was partially offset by approximately $99 million of revenue growth due to positive foreign exchange rate changes. The increase in Information Worker revenue for the six months ended December 31, 2004 was primarily attributable to a 4% or $157 million increase in retail and commercial licensing revenue and a 9% or $63 million increase in OEM revenue, including the impact of foreign exchange rates. Changes in foreign exchange rates accounted for approximately $196 million or four percentage points of the revenue growth for the first six months of fiscal 2005 as compared with the corresponding period in the prior fiscal year, offset by a $386 million decline in Upgrade Advantage earned revenue.  
Information Worker operating income growth for the three and six months ended December 31, 2004 was primarily due to a decrease in stock-based compensation expense. Operating expenses also declined due to a reduction in marketing campaign costs from the prior period associated with the launch of Office 2003. This has been partially offset by an increase in headcount-related costs from increased hiring and increases in salary and benefits.  
We will likely experience favorable exchange rate impacts in the third quarter of fiscal 2005 due to stronger foreign currencies compared to the U.S. dollar versus a year ago. We expect the continued reduction in Upgrade Advantage earned revenue to be partially offset by sustained momentum in our OEM and multi-year licensing offerings and increased purchasing of Office System 2003 as enterprises complete their product evaluations.

Microsoft Business Solutions 
Microsoft Business Solutions develops and markets business applications and related services designed to help small and mid-sized companies, large corporations and divisions of global enterprises efficiently use, manage, and analyze business resources. Microsoft Business Solutions products consist of Microsoft Great Plains, Microsoft Navision, Microsoft Axapta, Microsoft Solomon, Microsoft CRM, Microsoft Retail Management, other business applications, and the Microsoft Partner Program. Microsoft Business Solutions revenue is affected by the general economic environment, and enterprise information technology spending in particular. As announced in the fourth quarter of fiscal 2004, Microsoft Business Solutions now includes the SMS&P organization, which previously had been included in Information Worker. Microsoft Business Solutions results have been restated to reflect the reclassification of SMS&P for all periods presented. Also as a result of the reorganization, the Microsoft Partner Program became a component of Microsoft Business Solutions.  
Microsoft Business Solutions revenue remained flat in the second quarter of fiscal 2005 as compared with the corresponding period in the prior year. Growth in new licenses, renewed license agreements, and the Microsoft Partner Program subscriptions were offset by declines in services revenue and online business. Revenue from all of our business management applications grew quarter over quarter in both licenses and enhancements. The decline in service revenue is mainly attributed to a shift in our focus to encourage our partners to offer more of these services. For the first six months of fiscal 2005, the revenue increase was primarily due to an increase in revenue from Microsoft business management applications.  
Microsoft Business Solutions operating loss declined for the three and six months ended December 31, 2004 as compared with the corresponding periods in the prior year primarily due to a decrease in stock-based compensation expense. The operating loss in the same time periods also declined from the comparable period in fiscal 2004 due to reduced acquisition amortization expenses and higher Microsoft Business Solutions product revenue.  
Microsoft Business Solutions is committed to further developing its product offerings, with recently released product versions including Microsoft Great Plains 8.0 and Microsoft Solomon 6.0. In the second quarter of fiscal 2005, we launched Microsoft Navision 4.0, available in 39 languages and 41 localized versions. In addition, in the third quarter of fiscal 2005, we released Microsoft Business Solutions Small Business Financials North America Edition, a solution for small companies that require more than basic accounting software.

MSN 
MSN includes personal communications tools, such as e-mail and instant messaging, and online information offerings, such as MSN Search and the MSN portals and channels around the world. MSN also provides a variety of paid solutions including MSN Internet Access and MSN Premium Web Services. In the second quarter of fiscal 2005, we launched the MSN Toolbar Suite beta with Desktop Search functionality, which is intended to improve search efficiency for users on their Windows-based personal computer. Revenue is principally generated from advertisers on MSN, from consumers through subscriptions and transactions generated from MSN Premium Web Services, and from subscribers to MSN Narrowband Internet Access.  
MSN revenue increase for the second quarter of fiscal 2005 was primarily due to continued increases in MSN advertising revenue and subscriptions and transactions services other than Internet Access. Advertising revenue increased $49 million or 17% from the prior year due primarily to our strength in display advertising revenue and strong international growth. MSN launched the clarity in advertising program on July 1, 2004, which eliminated paid inclusion and reduced the number of advertisements that are returned with search results. As expected, this has tempered search revenue growth in the first six months of fiscal 2005. The increase in advertising revenue was partially offset by a decline of $33 million or 14% in Internet Access revenue, primarily from the migration of Internet Access subscribers to broadband or other competitively priced Internet service providers. Revenue from subscriptions and transactions services other than Internet Access increased $26 million in the second quarter of fiscal 2005 to $46 million. Internet Access subscribers declined 1.7 million from the same quarter last year to 3.5 million, while total subscribers grew 1.2 million from the same period last year to 9.3 million. MSN revenue for the six months ended December 31, 2004 increased due to a $105 million or 20% increase in advertising revenue and $47 million or 127% increase in subscriptions and transactions revenue. The revenue growth was partially offset by a decline of $61 million or 13% in Internet Access revenue. At the end of the first six months of fiscal 2005, MSN had over 380 million monthly unique users, 191 million active Hotmail accounts, and 156 million active Messenger accounts.  
MSN operating income growth for the three and six months ended December 31, 2004 was primarily due to a decrease in stock-based compensation expense. The operating income improvement in the second quarter was also attributable to increases in display advertising revenue, a decline in customer acquisition costs and other expenses related to the Internet Access business, partially offset by increases in other headcount-related costs resulting from increased hiring for sales and marketing initiatives. The increase in operating income for the first six months of fiscal 2005 was partially offset by a tax benefit of $48 million recorded in the first quarter of fiscal 2004.  
MSN expects advertising revenue and revenue from subscriptions and transactions for Premium Web services to continue to grow for the remainder of fiscal 2005. Advertising revenue should benefit from the relative strength of the Internet market and the related expected increases in Internet spending and additions to the advertising platform, communications innovations and an improved search engine. Advertising growth may be tempered by investments that MSN is making in improving the user experience. In some cases, the number of advertisements delivered either via our search tools or via our internet portals may be reduced in order to improve the overall user experience thereby helping to sustain and grow our user base. We expect revenue from narrowband Internet Access to continue declining in fiscal 2005 as narrowband subscribers continue to migrate to broadband Internet access. However, we expect the segment to continue to be profitable for the second half of fiscal 2005.

Mobile and Embedded Devices
Mobile and Embedded Devices includes Windows Mobile software, Windows Embedded operating systems, MapPoint, and Windows Automotive. These products extend the advantages of the Windows platform to mobile devices such as PDAs, phones, and a wide range of embedded devices. The business is also responsible for managing sales and customer relationships for Microsoft overall with device manufacturers and communication sector customers. The communication sector includes network service providers, such as wireless, fixed and cable and wireless operators, and media and entertainment companies. The market for products in these segments is intensely competitive. Competitive alternatives vary based on product lines and include products offerings from commercial and non-commercial mobile operating system providers, and proprietary software developed by OEMs and mobile operators. Short product lifecycles in product lines such as Windows Mobile software may impact our continuing revenue streams.  
Mobile and Embedded Devices revenue growth for the second quarter and first six months of fiscal 2005 was primarily due to strength in Windows Mobile software sales and the introduction of new MapPoint products. Increased revenue for Windows Mobile software was driven by increased shipments of connected mobile devices such as phone-enabled PDAs and Smartphones, and increased market share for standalone PDAs. For the three and six month periods ended December 31, 2004, revenue increased due to unit volume increases in all major product lines, especially Windows Mobile software and Windows Embedded operating systems. In the second quarter of fiscal 2005, revenue for Windows Mobile software increased $15 million or 50%, revenue for Windows Embedded operating systems increased $5 million or 24% and revenue for MapPoint and Windows Automotive increased $8 million or 67%. For the first six months ended December 31, 2004, revenue for Windows Mobile software increased $23 million or 47% compared to the comparable period of the prior year. Revenue for Windows Embedded operating systems increased $7 million or 17% and revenue for MapPoint and Windows Automotive increased $14 million or 54% in the same period.  
The Mobile and Embedded Devices operating loss for the three and six months ended December 31, 2004 decreased compared to the corresponding period in fiscal 2004 primarily due to a decrease in stock-based compensation expense. The growth in revenue and a reduction in sales and marketing expense also drove improved operating results in this period compared to the prior year. This has been partially offset by increased salary and benefit costs from increased hiring.  
We expect sales for Mobile and Embedded Devices to continue to be driven by an overall increase in customer demand for connectivity and an increase in the number of new devices being offered by OEMs and mobile operators based on Windows Mobile software and Windows Embedded operating systems.

INVESTMENT INCOME, INCOME TAXES, AND OTHER
Investment Income and Other 
The components of investment income and other are as follows:
 
Dividends and interest income declined in the three and six months ended December 31, 2004 as compared to the corresponding period in fiscal 2004 due to a higher allocation of funds to lower yielding, more liquid asset classes and a smaller portfolio balance following the payment of a $32.64 billion special dividend on December 2, 2004.  
Net realized gains on investments were relatively flat in the three months ended December 31, 2004 but declined in the six months ended December 31, 2004 due to fewer sales of investments during the first quarter of fiscal 2005. Net realized gains on investments include other-than-temporary impairments of $16 million and $39 million in the three and six months ended December 31, 2004 compared to $43 million and $61 million in the same periods in fiscal 2004.  
Derivative instruments are used to manage exposures to interest rates, equity prices, and foreign currency markets. Net derivative losses in the three months ended December 31, 2004 were primarily related to losses on equity derivatives used to economically hedge against a decline in equity prices. These losses were offset by the combination of realized gains on sales of equity securities and unrealized gains related to increases in the market value of the underlying assets included as a component of other comprehensive income. Net derivative losses in the six months ended December 31, 2004 were primarily related to losses on equity derivatives, interest rate derivatives, and foreign currency contracts. During the six months ended December 31, 2004, losses related to equity derivatives were $266 million and losses related to interest rate derivatives were $75 million. These losses were offset by the combination of realized gains on sales of equity securities and unrealized gains related to increases in the market value of the underlying assets included as a component of other comprehensive income. Losses related to foreign currency contracts were $163 million, related in part to hedging anticipated foreign currency revenues while the U.S. dollar generally declined against most currencies, and economically hedging foreign currency based investment exposures. Losses related to hedging foreign currency based investment exposures were offset by unrealized gains in the underlying assets. In the first and second quarter of fiscal 2004, losses related to derivatives were not significant.  
Net losses on equity investees and other for the prior period were reclassified into investment income and other to conform to the current period presentation.

Cost of revenue 
Cost of revenue includes manufacturing and distribution costs for products sold and programs licensed, operation costs related to product support service centers and product distribution centers, costs incurred to support and maintain Internet-based products and services, and costs associated with the delivery of consulting services. In addition to a decrease in the cost of revenue in the three and six months ended December 31, 2004 due to lower stock-based compensation expense, our cost of revenue decreased in the second quarter due to a $103 million reduction in product costs mainly due to cost efficiency in producing Xbox consoles and a $33 million reduction in costs primarily associated with the MSN Internet Access business. These decreases in the second quarter were partially offset by increased costs in product support and consulting services and other headcount-related costs. For the six months ended December 31, 2004, our cost of revenue decreased due to an $85 million reduction in costs primarily associated with the MSN Internet Access business and an $86 million reduction in product costs mainly due to Xbox consoles cost efficiency. This decrease was partially offset by increased costs in product support and consulting services and other headcount-related costs.

Research and development 
Research and development expenses include payroll, employee benefits, stock-based compensation and other headcount-related costs 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. Our research and development expenses decreased in the three and six months ended December 31, 2004 due to lower stock-based compensation expense. This was partially offset by an increase in product development costs associated with upcoming products, primarily the next generation of the Xbox console, the Windows Client next generation operating system (Longhorn) and product development in Mobile and Embedded devices.

Sales and marketing 
Sales and marketing expenses include payroll, employee benefits, stock-based compensation, and other headcount-related costs associated with sales and marketing personnel and advertising, promotions, tradeshows, seminars, and other programs. Our sales and marketing expenses decreased in the three and six months ended December 31, 2004 due to lower stock-based compensation expense. This was partially offset in the second quarter of fiscal 2005 by an increase in other headcount-related costs from new and existing employees of $90 million due to hiring and salary increases. For the six months ended December 31, 2004, the decrease in sales and marketing expense was partially offset by an increase of $187 million in headcount-related costs from hiring and salary increases and by an increase in marketing expense primarily related to global marketing programs and Home and Entertainment campaigns associated with the Halo 2 launch.

General and administrative 
General and administrative costs include payroll, employee benefits, stock-based compensation, and other headcount-related costs associated with finance, legal, facilities, certain human resources, other administrative headcount; and legal and other administrative fees. Our general and administrative expenses decreased in the three months ended December 31, 2004 due to lower stock-based compensation expense, partially offset by an increase in other headcount-related costs from new and existing employees of $16 million. For the six months ended December 31, 2004, our general and administrative expense increased mainly due to higher litigation expenses primarily driven by the $536 million Novell settlement recorded in the first quarter of fiscal 2005 and other headcount-related costs totaling approximately $18 million. This was partially offset by a reduction in stock-based compensation expense.

Income Taxes 
Our effective tax rate for the three and six month periods ended December 31, 2003 and 2004 was 33%.
On October 22, 2004, the President signed the American Jobs Creation Act of 2004 (the “Act”). The Act creates a temporary incentive for U.S. corporations to repatriate foreign subsidiary earnings by providing an elective 85% dividends received deduction for certain dividends from controlled foreign corporations. The Company may make this election with respect to dividends paid during either its fiscal year 2005 or 2006. The deduction is subject to a number of limitations and requirements, including adoption of a specific domestic reinvestment plan for the repatriated funds. On January 13, 2005 the U.S. Treasury published Notice 2005-10 providing guidance on the implementation of the repatriation deduction. Based on our current understanding of the Act, we believe that we may repatriate from $0 to approximately $780 million in dividends subject to the elective 85% dividends received deduction generating a corresponding tax provision benefit from $0 to approximately $179 million from the reversal of previously provided U.S. deferred tax liabilities on these unremitted foreign subsidiary earnings. We expect to confirm our understanding of this provision and seek the required chief executive officer and Board of Directors approval of the required domestic reinvestment plan within the timeframe the incentive is available.

FINANCIAL CONDITION 
Cash and short-term investments totaled $34.50 billion as of December 31, 2004 compared to $60.59 billion as of June 30, 2004. The decline is primarily attributable to a special dividend of $3.00 per share, or $32.64 billion, which was paid on December 2, 2004 to shareholders of record on November 17, 2004. Equity and other investments were $12.16 billion as of December 31, 2004 compared to $12.21 billion as of June 30, 2004. The investment portfolio consists primarily of fixed-income securities, diversified among industries and individual issuers. Our investments are generally liquid and investment grade. The portfolio is invested predominantly in U.S. dollar denominated securities, but also includes foreign currency positions in order to diversify financial risk. The portfolio is primarily invested in short-term securities to minimize interest rate risk and facilitate rapid deployment for immediate cash needs. As a result of a special dividend paid in December 2004 and shares repurchased, our retained deficit, including accumulated other comprehensive income was $11.17 billion at December 31, 2004. Our retained deficit is not expected to impact our future ability to operate or pay dividends given our continuing profitability and strong cash and financial position.

Unearned Revenue 
Unearned revenue from volume licensing programs represents customer billings, paid either upfront or annually at the beginning of each billing coverage period, that are accounted for as subscriptions with revenue recognized ratably over the billing coverage period. For certain other licensing arrangements, revenue attributable to undelivered elements, including free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis, is based on the sales price of the undelivered elements when sold separately and is recognized ratably on a straight-line basis over the related product’s life cycle.  
Unearned revenue as of December 31, 2004 increased $184 million from September 30, 2004, reflecting multi-year licensing billings that outpaced recognition of previous deferrals by $203 million and a $40 million decline in revenue deferred for undelivered elements. We earned approximately $7 million and $44 million from the Upgrade Advantage programs for the three and six months ended December 31, 2004 respectively as compared to $296 million and $674 million for the three and six months ended December 31, 2003.
See Note 5 – Unearned Revenue of the Notes to Financial Statements
The following table outlines the expected recognition of unearned revenue at December 31, 2004:

Cash Flows 
Cash flow from operations for the six months ended December 31, 2004 decreased $372 million from the first half of fiscal 2004 to $7.63 billion, due to the impact of a $1.16 billion decrease in other current liabilities, and a $1.83 billion increase in net income partially offset by the impact on net income of a $2.95 billion decrease in stock-based compensation expense. Cash used for financing was $34.41 billion in the first six months of fiscal 2005, an increase of $31.79 billion from the corresponding period in fiscal 2004. The increase reflects $34.37 billion of cash dividends paid in the first and second quarters of fiscal 2005. The increase was partially offset by a reduction in cash used for common stock repurchases which was $1.32 billion in the first six months of fiscal 2005 compared to $1.78 billion in the first six months of fiscal 2004. Net cash from investing was $15.30 billion in the first six months of fiscal 2005, an increase of $21.00 billion from the first six months of fiscal 2004, primarily due to a $23.26 billion increase in investment maturities that occurred to fund the cash dividends paid in the current quarter.  
We have no material long-term debt. Stockholders’ equity at December 31, 2004 was $47.23 billion. We will continue to invest in sales, marketing, product support infrastructure, and existing and advanced areas of technology. Additions to property and equipment will continue, including new facilities and computer systems for research and development, sales and marketing, support, and administrative staff. We have operating leases for most U.S. and international sales and support offices. We have issued residual value guarantees in connection with various operating leases. These guarantees provide that if we do not purchase the leased property from the lessor at the end of the lease term, then we are liable to the lessor for an amount equal to the shortage (if any) between the proceeds from the sale of the property and an agreed value. As of December 31, 2004, the maximum amount of the residual value guarantees was approximately $271 million. We believe that proceeds from the sale of properties under operating leases would exceed the payment obligation and therefore no liability currently exists. 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 requirements for capital resources. 
On July 20, 2004, our Board of Directors approved a quarterly dividend of $0.08 per share, or approximately $870 million which was paid on September 14, 2004, to shareholders of record on August 25, 2004. In addition, on July 20, 2004, our Board of Directors approved a special dividend of $3.00 per share, or $32.64 billion, which was paid on December 2, 2004 to shareholders of record on November 17, 2004. On September 15, 2004, our Board of Directors declared a regular quarterly dividend of $0.08 per share which was paid December 2, 2004, to shareholders of record at the close of business on November 17, 2004. On December 8, 2004, our Board of Directors declared a regular quarterly dividend of $0.08 per share, which is payable March 10, 2005, to shareholders of record at the close of business on February 17, 2005. The ex-dividend date will be February 15, 2005. This dividend of approximately $870 million was included in other current liabilities on our balance sheet.  
During the three months ended December 31, 2004, we repurchased 23.6 million shares of common stock for $655 million, compared to 30.5 million shares of common stock for $830 million in the comparable period of the prior year. During the six months ended December 31, 2004, we repurchased 46.4 million shares of common stock for $1.28 billion, compared to 73.8 million shares of common stock for $2.02 billion in the comparable period of the prior year. On July 20, 2004, our Board of Directors approved a plan to repurchase up to $30 billion of common stock over the following four years, of which we have repurchased $1.28 billion as of December 31, 2004. The repurchase program may be suspended or discontinued at any time without prior notice. In any period, cash used in financing activities related to common stock repurchased may differ from the comparable change in stockholders’ equity, reflecting timing differences between the recognition of share repurchase transactions and their settlement for cash.  
We believe existing cash and short-term investments, together with funds generated from operations should be sufficient to meet operating requirements and regular quarterly dividends and planned share repurchases. Our philosophy regarding the maintenance of a balance sheet with a large component of cash and short-term investments, and equity and other investments, reflects our views on potential future capital requirements relating to research and development, creation and expansion of sales distribution channels, investments and acquisitions, share dilution management, legal risks, and challenges to our business model. We regularly assess our investment management approach in view of our current and potential future needs.

Off-balance sheet arrangements 
As of June 30, 2004, we had guaranteed the repayment of certain Japanese yen denominated bank loans and related interest and fees of Jupiter Telecommunication, Ltd., a Japanese cable company (Jupiter). The total amount of these guarantees was approximately $51 million. Effective December 21, 2004, the unconditional guarantees were terminated.  
We provide indemnifications of varying scope and amount to customers against claims of intellectual property infringement made by third parties arising from the use of our products. We evaluate estimated losses for such indemnifications under SFAS 5, Accounting for Contingencies, as interpreted by FIN 45. We consider factors such as the degree of probability of an unfavorable outcome and the ability to make a reasonable estimate of the amount of loss. To date, we have not encountered material costs as a result of such obligations and do not believe that it is currently probable that we have material costs to support such indemnifications, and accordingly have not accrued a liability in our financial statements.

RECENTLY ISSUED ACCOUNTING STANDARDS  
In September 2004, the Financial Accounting Standards Board (FASB) issued FASB Staff Position (FSP) Emerging Issues Task Force (EITF) Issue 03-1-1, Effective Date of Paragraphs 10–20 of EITF Issue No. 03-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments”, which delays the effective date for the recognition and measurement guidance in EITF Issue No. 03-1. In addition, the FASB has issued a proposed FSP to consider whether further application guidance is necessary for securities analyzed for impairment under EITF Issue No. 03-1. We continue to assess the potential impact that the adoption of the proposed FSP could have on our financial statements.  
In November 2004, the FASB issued Statement of Financial Accounting Standards (SFAS) No. 151, Inventory Costs, which clarifies the accounting for abnormal amounts of idle facility expense, freight, handling costs, and wasted material. SFAS No. 151 will be effective for inventory costs incurred during fiscal years beginning after June 15, 2005. We do not believe the adoption of SFAS No. 151 will have a material impact on our financial statements.  
In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets, which eliminates the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. SFAS No. 153 will be effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. We do not believe the adoption of SFAS No. 153 will have a material impact on our financial statements.  
In December 2004, the FASB issued SFAS No. 123(R), Share-Based Payment, which establishes standards for transactions in which an entity exchanges its equity instruments for goods or services. This standard requires a public entity to measure the cost of employee services received in exchange for an award of equity instruments based on the grant-date fair value of the award. This eliminates the exception to account for such awards using the intrinsic method previously allowable under APB Opinion No. 25. SFAS No. 123(R) will be effective for interim or annual reporting periods beginning on or after June 15, 2005. We previously adopted the fair value recognition provisions of SFAS No. 123, Accounting for Stock-Based Compensation, on July 1, 2003 and restated prior periods at that time for all awards granted to employees after July 1, 1995. Accordingly we believe SFAS No. 123(R) will not have a material impact on our balance sheet or income statements. We continue to assess the potential impact that the adoption of SFAS No. 123(R) could have on our statements of cash flows.

APPLICATION OF CRITICAL ACCOUNTING POLICIES  
Our financial statements and accompanying notes are prepared in accordance with U.S. GAAP. Preparing financial statements requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue, and expenses. These estimates and assumptions are affected by management’s application of accounting policies. Critical accounting policies for us include revenue recognition, impairment of investment securities, impairment of goodwill, accounting for research and development costs, accounting for legal contingencies, and accounting for income taxes.  
We account for the licensing of software in accordance with American Institute of Certified Public Accountants (AICPA) Statement of Position (SOP) 97-2, Software Revenue Recognition. The application of SOP 97-2 requires judgment, including whether a software arrangement includes multiple elements, and if so, whether vendor-specific objective evidence (VSOE) of fair value exists for those elements. Customers receive certain elements of our products over a period of time. These elements include free post-delivery telephone support and the right to receive unspecified upgrades/enhancements of Microsoft Internet Explorer on a when-and-if-available basis, the fair value of which is recognized over the product’s estimated life cycle. Changes to the elements in a software arrangement, the ability to identify VSOE for those elements, the fair value of the respective elements, and changes to a product’s estimated life cycle could materially impact the amount of earned and unearned revenue. Judgment is also required to assess whether future releases of certain software represent new products or upgrades and enhancements to existing products.  
SFAS 115, Accounting for Certain Investments in Debt and Equity Securities, and Securities and Exchange Commission (SEC) Staff Accounting Bulletin (SAB) 59, Accounting for Noncurrent Marketable Equity Securities, provide guidance on determining when an investment is other-than-temporarily impaired. Investments are reviewed quarterly for indicators of other-than-temporary impairment. This determination requires significant judgment. In making this judgment, we evaluate, among other factors, the duration and extent to which the fair value of an investment is less than its cost; the financial health of and near-term business outlook for the investee, including factors such as industry and sector performance, changes in technology, and operational and financing cash flow; and our intent and ability to hold the investment. Investments with an indicator are further evaluated to determine the likelihood of a significant adverse effect on the fair value and amount of the impairment as necessary. If market, industry and/or investee conditions deteriorate, we may incur future impairments.  
SFAS 142, Goodwill and Other Intangible Assets, requires that goodwill be tested for impairment at the reporting unit level (operating segment or one level below an operating segment) on an annual basis (July 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, 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 using a discounted cash flow methodology. This 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, the useful life over which cash flows will occur, and determination of our weighted average cost of capital. Changes in these estimates and assumptions could materially affect the determination of fair value and/or goodwill impairment for each reporting unit.
We account for research and development costs in accordance with several accounting pronouncements, including SFAS 2, Accounting for Research and Development Costs, and SFAS 86, Accounting for the Costs of Computer Software to be Sold, Leased, or Otherwise Marketed. SFAS 86 specifies that costs incurred internally in researching and developing a computer software product should be charged to expense until technological feasibility has been established for the product. Once technological feasibility is established, all software costs should be 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 shortly before the products are released to manufacturing. Costs incurred after technological feasibility is established are not material, and accordingly, we expense all research and development costs when incurred.  
The outcomes of legal proceedings and claims brought against us are subject to significant uncertainty. SFAS 5, Accounting for Contingencies, requires that an estimated loss from a loss contingency such as a legal proceeding or claim should be 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. Disclosure of a contingency is required if there is at least a reasonable possibility that a loss has been incurred. 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 financial position or our results of operations.  
SFAS 109, Accounting for Income Taxes, establishes financial accounting and reporting standards for the effect of 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. Judgment is required in assessing the future tax consequences of events that have been recognized in our financial statements or tax returns. Variations in the actual outcome of these future tax consequences could materially impact our financial position or our results of operations.  
We account for stock-based compensation in accordance with the fair value recognition provisions of SFAS 123, Accounting for Stock-Based Compensation. Under the fair value recognition provisions of SFAS 123, stock-based compensation cost is measured at the grant date based on the value of the award and is recognized as expense over the vesting period. Determining the fair value of stock-based awards at the grant date requires judgment, including estimating the expected term of stock options, the expected volatility of our stock, expected dividends, and risk-free interest rates. In addition, judgment is also required in estimating the amount of stock-based awards that are expected to be forfeited. If actual results differ significantly from these estimates, stock-based compensation expense and our results of operations could be materially impacted.

ISSUES AND UNCERTAINTIES 
This Quarterly Report on Form 10-Q contains statements that are forward-looking. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of issues and uncertainties such as those listed below and elsewhere in this report, which, among others, should be considered in evaluating our future financial performance.