utils/texts/financial_report_text.txt

1998

Letter to shareholders
We had a huge effect on the Internet. And it had a huge effect on us.During Microsoft's 21-year history, the pace of innovation has been quite rapid. This past year stands out both for the exciting new products and the broad recognition that computers will revolutionize communications. Windows® 95 was launched, and 40 million people were introduced to its benefits: ease of use, 32-bit applications, and increased productivity. Windows NT® established phenomenal sales momentum and gained widespread acceptance as the foundation for the enterprise market and a new generation of corporate intranets and Web servers. 
The Internet came of age, and Microsoft embraced the opportunity by enhancing its entire range of products and services to create the best Web experience for everyone from the casual Web surfer to the corporate IT manager. Microsoft is betting that over the next decade Internet use will grow dramatically. Next year research and development spending, broadly defined, will grow to more than $2 billion, at a growth rate faster than sales. Our R&D is driven by customer feedback and our belief that there are many breakthroughs in software that we can achieve by taking a long-term approach. 
In our dialog with the financial community, we go out of our way to point out the challenges of maintaining or increasing our profitability. This conservatism is part of our culture. Despite this, we feel the prospects for our business over the next decade are very strong. 
I want to thank our employees, customers, partners, and shareholders for all of their support in building Microsoft.
MANAGEMENT'S DISCUSSION AND ANALYSIS
RESULTS OF OPERATIONS FOR 1996, 1997, AND 1998

Microsoft develops, manufactures, licenses, and supports a wide range of
software products, including scalable operating systems for intelligent devices,
personal computers (PCs), and servers; server applications for client/server
environments; business and consumer productivity applications; software
development tools; and Internet and intranet software and technologies.  The
Company's interactive efforts include entertainment and information software
programs; MSN, the Microsoft Network online service; Internet-based services;
and alliances with companies involved with various forms of digital
interactivity.  Microsoft also sells personal computer input devices and books,
and researches and develops advanced technologies for future software products.

REVENUE
The Company's revenue growth rate continued to slow, from 46% in the fiscal year
ended June 30, 1996 and 31% in fiscal 1997 to 28% in fiscal 1998.  Revenue
growth was particularly strong in 1996 due to the retail introduction of the
Microsoft Windows 95 operating system.  The 1997 and 1998 growth rates, although
slower than that of 1996, reflected the continued adoption of Windows 32-bit
operating systems and Microsoft Office 97, particularly as Microsoft software is
deployed across entire corporate, academic, and governmental organizations.
Software license volume increases have been the principal factor in Microsoft's
revenue growth.  The average selling price per license has decreased, primarily
because of general shifts in the sales mix from retail packaged products to
licensing programs, from new products to product upgrades, and from stand-alone
desktop applications to integrated product suites.  Average revenue per license
from original equipment manufacturer (OEM) licenses and organization license
programs is lower than average revenue per license from retail versions.
Likewise, product upgrades have lower prices than new products. Also, prices of integrated suites, such as Microsoft Office,
are less than the sum of the prices for the individual programs included in
these suites when such programs are licensed separately. During each of the
three years an increased percentage of products and programs included elements
which were billed but unearned and recognized ratably, such as Windows operating
systems, Office 97, maintenance, and other subscription models. See accompanying
notes.
PRODUCT GROUPS. Platform product revenue was $4.11 billion, $5.97 billion, and
$7.64 billion in 1996, 1997, and 1998.  Platform revenue is primarily licenses
of PC operating systems; business systems with client/server, Internet, and
intranet architectures; and software development tools.
The Company's principal desktop platform products are its 32-bit operating
systems: Windows 95, Windows 98, and Windows NT Workstation.  Released in August
1995, Windows 95 was a successor to the MS-DOS(R) and Microsoft Windows 3.x
operating systems.  Windows NT Workstation version 4.0 was released in fiscal
1997.  Windows 98 became available at the end of fiscal 1998.  Although the
growth rate of new PC shipments slowed, desktop operating systems contributed to
revenue growth as shipments of new PCs preinstalled with such systems increased
during the three-year period.  Additionally, increased penetration of higher
value 32-bit operating systems, particularly Windows NT Workstation, led to
growth in 1996, 1997, and 1998.  In 1996, retail license sales of Windows 95
were a major factor in the Platform revenue increase, reflecting the typical
sales pattern for major operating system upgrades.  Also in 1996, a portion of
Windows operating system revenue became subject to ratable recognition.
Business systems products offer an enterprise-wide distributed client/server,
Internet, and intranet environment based on the Microsoft Windows NT Server
operating system, Microsoft Exchange Server, Microsoft SQL Server, and other
server applications in the Microsoft BackOffice (R) family of products. Revenue
from these products increased strongly due to greater corporate demand,
particularly for intranet solutions, although the growth rate slowed in 1998.
Although revenue was not significant, sales of WebTV terminals and service and
preinstallations of Windows CE by OEMs on intelligent devices were strong in
1998.
Independent software vendors, corporate developers, and solutions developers
license tools such as the Microsoft Visual Basic(R) development system to
develop software for Windows operating systems and the Internet.  Revenue from
developer products increased steadily in 1996 and 1997 and was flat in 1998.
Applications and Content revenue was $4.56 billion, $5.39 billion, and $6.84
billion in 1996, 1997, and 1998.  Applications and Content revenue includes
primarily licenses of desktop and consumer productivity applications,
interactive media programs, and PC input devices.  Microsoft Office for Windows
95 was released in fiscal 1996 and Microsoft Office 97 was released in fiscal
1997.  Applications and Content revenue grew 27% in 1996, 18% in 1997, and 27%
in 1998.  The lower growth rate in 1997 was due primarily to the application of
the ratable revenue recognition model for Office 97.
Absolute increases in desktop applications revenue during the three-year period
were led by the various Microsoft Office integrated suites, including Standard,
Professional, and Small Business Editions.  The primary programs in Microsoft
Office are the word processor Microsoft Word, Microsoft Excel spreadsheet, and
Microsoft PowerPoint(R) presentation graphics program.  Various versions of
Office, which are available for the 32-bit version of Windows, the 16-bit
version of Windows, and Macintosh operating systems, also include Microsoft
Access database management program, Microsoft Outlook(TM) messaging and
collaboration client, or other programs.  Revenue from stand-alone versions of
Microsoft Excel, Word, and PowerPoint continued to decrease as the sales mix shifted to integrated
product suites. Microsoft Project scheduling and project management program
revenue increased during the three-year period.
Microsoft offers a broad range of interactive media products, which also showed
moderate growth.  Products include CD-ROM multimedia reference titles and
programs for home and small office productivity, children's creativity, and
entertainment.  In addition to the Microsoft Network, online Internet services
include travel information and reservations, local event information, and car
buying information.
The Company also markets input devices.  Mouse and gaming device sales increased
while keyboard revenue was steady during the three-year period.
SALES CHANNELS. The Company distributes its products primarily through OEM
licenses, organization licenses, and retail packaged products.  OEM channel
revenue represents license fees from original equipment manufacturers.
Microsoft has three major sales and marketing geographies: the United States and
Canada, Europe, and elsewhere in the world (Other International).  Sales of
organization licenses and packaged products in these channels are primarily to
distributors and resellers.  The trend has continued toward a higher percentage
of organization licensing versus packaged products.
OEM channel revenue was $2.50 billion in 1996, $3.48 billion in 1997, and $4.72
billion in 1998.  The primary source of OEM revenue is the licensing of desktop
operating systems, and OEM revenue is highly dependent on PC shipment volume.
U.S. and Canadian channel revenue was $2.68 billion, $3.41 billion, and $4.36
billion in 1996, 1997, and 1998.  Revenue in Europe was $2.02 billion, $2.54
billion, and $3.15 billion in 1996, 1997, and 1998.  Growth rates have been
lower in Europe than in other geographic areas due to higher existing market
shares and a more dramatic shift to licensing programs.  Other International
channel revenue was $1.47 billion in 1996, $1.93 billion in 1997, and $2.26
billion in 1998.  Growth rates were higher in the Other International channel in
1996 and 1997 due to customers accepting newly localized products, particularly
in Japan, and penetration in emerging markets.  However, revenue was relatively
flat in Japan and Southeast Asia in 1998 due to economic issues and weak
currencies.
The Company's operating results are affected by foreign exchange rates.
Approximately 34%, 32%, and 34% of the Company's revenue was collected in
foreign currencies during 1996, 1997, and 1998.  Since a portion of local
currency revenue is hedged and much of the Company's international manufacturing
costs and operating expenses are also incurred in local currencies, the impact
of exchange rates is partially mitigated.

OPERATING EXPENSES
COST OF REVENUE. As a percentage of revenue, cost of revenue was 13.7% in 1996,
9.6% in 1997, and 8.3% in 1998.  The decrease was due to the shifts in mix to
CD-ROMs (which carry lower cost of goods than disks), licenses to OEMs and
organizations, and higher-margin Windows NT Server, other servers, and client
access licenses in the BackOffice product family.  In 1998, the decrease was
offset somewhat by costs of WebTV.

RESEARCH AND DEVELOPMENT. Microsoft continued to invest heavily in the future by
funding research and development (R&D).  Expense increases of 67% in 1996, 34%
in 1997, and 30% in 1998 resulted primarily from development staff headcount
growth and higher levels of third-party development costs in many areas,
particularly Windows-based platforms, including desktop operating systems,
server systems, and consumer appliances, along with Internet and intranet technologies. R&D costs
also increased for desktop and server applications, development tools, and
interactive media initiatives such as MSN and other online services.
In August 1997, the Company acquired WebTV Networks, Inc., an online service
that enables consumers to experience the Internet through their televisions via
set-top terminals.  Microsoft paid $425 million in stock and cash.  The
accompanying income statement reflects a one-time write-off of in-process
technologies under development by WebTV Networks of $296 million.
SALES AND MARKETING. The increase in the absolute dollar amount of sales and
marketing expenses in the three-year period was due primarily to expanded
product-specific marketing programs, such as Windows 95 in 1996, Office 97 in
1997, and Windows 98 in 1998.  Sales and marketing costs as a percentage of
revenue decreased due to moderate headcount growth.  Microsoft brand advertising
and product support expenses declined in 1997, but rose slightly in 1998.
GENERAL AND ADMINISTRATIVE. Increases in general and administrative expenses
were attributable to higher legal costs and growth in the number of people and
computer systems necessary to support overall increases in the scope of the
Company's operations.
OTHER EXPENSES. Other expenses increased due to recognition of Microsoft's share
of joint venture activities, including DreamWorks Interactive and the MSNBC
entities.

INTEREST INCOME AND INCOME TAXES
Interest income increased primarily as a result of a larger investment portfolio
generated by cash from operations.  The effective income tax rate was 35.0% in
1996 and 1997.  The effective income tax rate increased to 36.9% in 1998 due to
the nondeductible write-off of WebTV in-process technologies.

NET INCOME
Net income as a percent of revenue increased in 1996, 1997, and 1998 due to the
lower relative cost of revenue, sales and marketing expenses, and general and
administrative expenses, partially offset by investments in research and
development, joint ventures, and WebTV.

FINANCIAL CONDITION
Microsoft's cash and short-term investment portfolio totaled $13.93 billion at
June 30, 1998.  The portfolio is diversified among security types, industries,
and individual issuers.  Microsoft's 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
anticipation of continued international expansion.  The portfolio is primarily
invested in short-term securities to minimize interest rate risk and facilitate
rapid deployment in the event of immediate cash needs.
Microsoft also invests in equities, including financial investments and
strategic technology companies in many areas.  During 1997, Microsoft invested
$1.0 billion in Comcast Corporation, a cable television and diversified
telecommunications company.  Comcast Special Class A common stock and
convertible preferred stock are included in equity investments at fair market
value on the balance sheet.
During 1996, Microsoft and National Broadcasting Company (NBC) established two
MSNBC joint ventures: a 24-hour cable news and information channel and an
interactive online news service.  Microsoft agreed to pay $220 million over a
five-year period for its interest in the cable venture, to pay one-half of operational funding of both joint ventures for a multiyear period, and to
guarantee a portion of MSNBC debt.
Microsoft has no material long-term debt and has $100 million of standby
multicurrency lines of credit to support foreign currency hedging and cash
management.  Stockholders' equity at June 30, 1998 was $16.63 billion.
Microsoft will continue to invest in sales, marketing, and product support
infrastructure.  Additionally, research and development activities will include
investments in existing and advanced areas of technology, including using cash
to acquire technology and to fund ventures and other strategic opportunities.
Additions to property and equipment will continue, including new facilities and
computer systems for research and development, sales and marketing, support, and
administrative staff.  Commitments for constructing new buildings were $420
million on June 30, 1998.
Cash will also be used to repurchase common stock to provide shares for employee
stock option and purchase plans.  The buyback program has not kept pace with
employee stock option grants or exercises.  Beginning in fiscal 1990, Microsoft
has repurchased 347 million common shares while 807 million shares were issued
under the Company's employee stock option and purchase plans.  The market value
of all outstanding stock options was $48 billion as of June 30, 1998.  Microsoft
enhances its repurchase program by selling put warrants.  During December 1996,
Microsoft issued 12.5 million shares of 2.75% convertible preferred stock.  Net
proceeds of $980 million were used to repurchase common shares.
Management believes existing cash and short-term investments together with funds
generated from operations will be sufficient to meet operating requirements for
the next 12 months.  Microsoft's cash and short-term investments are available
for strategic investments, mergers and acquisitions, other potential large-scale
cash needs that may arise, and to fund an increased stock buyback program over
historical levels to reduce the dilutive impact of the Company's employee stock
option and purchase programs.
Microsoft has not paid cash dividends on its common stock.  The preferred stock
pays $2.196 per annum per share.

ISSUES AND UNCERTAINTIES
Microsoft does not provide forecasts of future financial performance.  While
Microsoft management is optimistic about the Company's long-term prospects, the
following issues and uncertainties, among others, should be considered in
evaluating its growth outlook.

RAPID TECHNOLOGICAL CHANGE AND COMPETITION.  Rapid change, uncertainty due to
new and emerging technologies, and fierce competition characterize the PC
software industry.  The pace of change has recently accelerated due to the
Internet and new programming languages, such as Java.

FUTURE INITIATIVES.  The Company is expanding its efforts to provide and support
mission-critical systems to large enterprises.  Scalability of BackOffice server
and application products, total cost of ownership of Windows- and Office-based
systems, information storage unification, user interface simplification, and
Internet and intranet integration are also major focus areas.  Additionally,
Microsoft is committed to providing technologies, operating systems, and
interactive content for the future convergence of PCs, televisions, and the
Internet.  Future revenue from these initiatives may not duplicate historical
revenue growth rates.

PC GROWTH RATES.  The underlying PC unit growth rate and percentage of new PCs
acquired as replacement units directly impact the Company's software revenue
growth.  The PC shipment growth rate may continue to decrease and the
replacement rate may continue to increase, reducing future software revenue
opportunity.

PRODUCT SHIP SCHEDULES.  Delays in new-product releases dampen revenue growth
rates and can cause operational inefficiencies that impact manufacturing and
distribution logistics, independent software vendor (ISV) and OEM relationships,
and customer support expenses.

CUSTOMER ACCEPTANCE.  While the Company performs extensive usability and beta
testing of new products, user acceptance and corporate penetration rates
ultimately dictate the success of development and marketing efforts.

PRICES.  Future product prices may decrease from historical levels, depending on
competitive market and cost factors.  European and Asian software prices vary by
country and are generally higher than in the United States to cover localization
costs and higher costs of distribution.  Increased global license agreements,
European monetary unification, or other factors could erode such price uplifts
in the future.

EARNINGS PROCESS.  An increasingly higher percentage of the Company's revenue is
subject to ratable recognition.  Subsequent product support and delivery of
unspecified enhancements require the applicable portion of revenue for certain
products to be recognized over the product's life cycle.  This policy may be
required for additional products, depending on specific license terms and
conditions.  Also, maintenance and other subscription programs may continue to
increase in popularity, particularly with organizations.

SATURATION.  Product upgrades, which enable users to upgrade from earlier
versions of the Company's products or from competitors' products, have lower
prices and margins than new products.  As the desktop applications market has
become saturated, the sales mix has shifted from standard products to upgrade
products.  This trend is likely to continue.

ORGANIZATION LICENSES.  Average revenue per unit from organization license
programs is lower than average revenue per unit from retail versions shipped
through the finished goods channels.  Unit sales under licensing programs may
continue to increase.

CHANNEL MIX.  Average revenue per license is lower from OEM licenses than from
retail versions, reflecting the relatively lower direct costs of operations in
the OEM channel.  An increasingly higher percentage of revenue was achieved
through the OEM channel during 1997 and 1998.

COST OF REVENUE.  Although cost of revenue as a percentage of revenue decreased
in 1997 and 1998, it varies with channel mix, product mix within channels, and
usage of online operations.  The trend of declining cost of revenue as a
percentage of revenue is unlikely to continue in 1999.

PAY AND PARTICIPATION MODEL.  Microsoft employees currently receive salaries,
incentive bonuses, other fringe benefits, and stock options.  New government
regulations, poor stock price performance, or other factors could diminish the
value of the option program to current and prospective employees and force the
Company into more of a cash compensation model.  Had the Company paid employees
in cash the grant date Black-Scholes value of options vested in 1996, 1997, and
1998, the pretax expense would have been approximately $450 million, $620
million, and $850 million.

LONG-TERM RESEARCH AND DEVELOPMENT INVESTMENT CYCLE.  Developing and localizing
software is expensive and the investment in product development often involves a
long payback cycle.  The Company plans to continue significant investments in
software research and development and related product opportunities from which
significant revenue is not anticipated for a number of years.  Management
expects total spending for research and development in 1999 to increase over
spending in 1998.

SALES, MARKETING, AND SUPPORT INVESTMENTS.  The Company's plans for 1999 include
accelerated investments in its sales, marketing, and support groups.

FOREIGN EXCHANGE.  A large percentage of the Company's sales, costs of
manufacturing, and marketing is transacted in local currencies.  As a result,
the Company's international results of operations are subject to foreign
exchange rate fluctuations.

INVESTMENTS VALUE SENSITIVITY.  The Company's investment portfolio is subject to
interest rate and market price risk.  A 10% increase in treasury security yields
would reduce the carrying value of interest-sensitive securities at June 30,
1998 by $128 million, and a 10% decrease in market values would reduce the
carrying value of the Company's publicly traded equity securities by $300
million.  Many of these equity securities are highly volatile stocks.

INTELLECTUAL PROPERTY RIGHTS.  Microsoft diligently defends its intellectual
property rights, but unlicensed copying of software represents a loss of revenue
to the Company.  While this adversely affects U.S. revenue, revenue loss is even
more significant outside of the United States, particularly in countries where
laws are less protective of intellectual property rights.  Throughout the world,
Microsoft actively educates consumers on the benefits of licensing genuine
products and educates lawmakers on the advantages of a business climate where
intellectual property rights are protected.  However, continued efforts may not
affect revenue positively.

FUTURE GROWTH RATE.  The revenue growth rate in 1999 may not approach the level
attained in prior years.  As discussed previously, operating expenses are
expected to increase in 1999.  Because of the fixed nature of a significant
portion of such expenses, coupled with the possibility of slower revenue growth,
operating margins in 1999 may decrease from those in 1998.
LITIGATION.  Litigation regarding intellectual property rights, patents, and
copyrights occurs in the PC software industry.  In addition, there are
government regulation and investigation risks along with other general corporate
legal risks.

YEAR 2000.  The Year 2000 presents potential concerns for business and consumer
computing.  The consequences of this issue may include systems failures and
business process interruption.  It may also include additional business and
competitive differentiation.  Aside from the well-known calculation problems
with the use of 2-digit date formats as the year changes from 1999 to 2000, the
Year 2000 is a special case leap year and in many organizations using older
technology, dates were used for special programmatic functions.
The problem exists for many kinds of software and hardware, including
mainframes, mini computers, PCs, and embedded systems.  Microsoft is in the
process of gathering, testing, and producing information about Microsoft
technologies impacted by the Year 2000 transition.  First, Microsoft classified
its core products into categories of compliance: compliant, compliant with minor
issues, and not compliant.  Second, if a product is stated to be non-compliant,
Microsoft will provide information as to how an organization could bring that
product into compliance.  Microsoft is issuing patches and/or workarounds at no
additional charge for most issues.  Third, Microsoft is working to help
organizations find solutions to Year 2000 problems.  The technologies and
services offered by Microsoft and companies it works with can be components in
overall Year 2000 solutions.  Microsoft is assisting companies with the task of
recognizing how disparate technologies can fit together to create a viable
solution set.
Current information about the Company's product, business, and technical
concerns is available at the Microsoft Year 2000 Resource Center Web site
(www.microsoft.com/year2000).  The Web site also contains information about
obtaining software patches to resolve various Year 2000 issues in certain Microsoft products.  Information on the Company's Web site is provided to
customers for the sole purpose of assisting in planning for the transition to
the Year 2000.  Such information is the most currently available concerning the
behavior of the Company's products in the next century and is provided "as is"
without warranty of any kind.  However, variability of definitions of
"compliance" with the Year 2000 and of different combinations of software,
firmware, and hardware will likely lead to lawsuits against the Company.  The
outcome of such lawsuits and the impact on the Company are not estimable at this
time.
The Year 2000 issue also affects the Company's internal systems, including
information technology (IT) and non-IT systems.  Microsoft is assessing the
readiness of its systems for handling the Year 2000.  Although the assessment is
still underway, management currently believes that all material systems will be
compliant by the Year 2000 and that the cost to address the issues is not
material.  Nevertheless, Microsoft is creating contingency plans for certain
internal systems.
All organizations dealing with the Year 2000 must address the effect this issue
will have on their third-party supply chain.  Microsoft is undertaking steps to
identify its vendors and to formulate a system of working with key third-parties
to understand their ability to continue providing services and products through
the change to 2000.  Microsoft will work directly with its key vendors,
distributors, and resellers,  and partner with them if necessary, to avoid any
business interruptions in 2000.  For these key third-parties, contingency plans
will be developed.
Resolving Year 2000 issues is a worldwide phenomenon that will likely absorb a
substantial portion of IT budgets and attention in the near term.  Certain
industry analysts believe the Year 2000 issue will accelerate the trend toward
distributed PC-based systems from mainframe systems, while others believe a
majority of IT resources will be devoted to fixing older mainframe software in
lieu of large-scale transitions to systems based on software such as that sold
by Microsoft.  The impact of the Year 2000 on future Microsoft revenue is
difficult to discern but is a risk to be considered in evaluating future growth
of the Company.