FOOL CONFERENCE CALL SYNOPSIS*
By Debora Tidwell (TMF Debit)

Microsoft Corporation
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One Microsoft Way
Redmond, WA 98052-6399
(206) 882-8080
http://www.microsoft.com

UNION CITY, CA (April 24, 1997)/FOOLWIRE/ --- Microsoft Corporation released their third quarter 1997 earnings on April 18th after the market close. The company reported net income for the quarter of $1.04 billion. Earnings per share were $0.79, up 80% over last year's third quarter earnings per share of $0.44. Revenues totaled $3.21 billion, up 45% from $2.21 billion for last year's third quarter.

COST OF REVENUES. Cost of revenues declined to 9.3% of net revenues from 13.4% in Q3 last year and 11% in Q2 this year. This was due to the continued shift in mix to CD-ROMs, increased licenses to OEMs and corporations, increased efficiencies through outsourcing, lower materials costs, reduced scrap, and scale efficiencies.

OPERATING EXPENSES. R&D expenses increased 35% over Q3 last year to $492 million but was only up 1% sequentially. The increases were due primarily to headcount, third-party development, and IPR writeoffs, with the key beneficiaries being server products and the interactive media group (which includes MSN). Sales and marketing expense was $750 million or 23.5% of revenue, down from 27.5% sequentially and 31.1% year over year. The drivers here were declines in product support costs due to increased efficiencies and increased revenues. G&A costs were $101 million, up from $81 million sequentially due to a settlement regarding state excise tax.

NON-OPERATING LINES. Interest income was $119 million which was up from $105 million sequentially due to the larger average investment portfolio during the quarter, generated primarily by cash from operations. Other expenses including those related to joint ventures increased mostly due to investment writeoffs.

BALANCE SHEET. Total assets decreased to $12.6 billion from $12.8 billion sequentially due primarily to the repurchase of common stock. Cash and short-term investments totalled $9.1 billion which was also down slightly sequentially due to stock repurchase. Accounts receivable was down from $975 million in Q2 to $866 million in Q3 due to Office '97 receivables collected and improvements in DSOs. Property, plant and equipment increased $49 million sequentially, mostly due to the ongoing expansion of the company's Redmond campus. Equity investments were essentially flat sequentially at $819 million. Unearned revenues increased to $1.29 billion, up $272 million sequentially. Of this, about $765 million represented the unearned portion of operating system revenues. They expected that Office '97 would have similar accounting treatment to these operating system products and this was the case. Therefore, unearned revenues associated with the product in Q3 grew to $150 million and unearned revenues associated with upgrade coupons for the product totalled $190 million. The balance of unearned revenues was attributable to maintenance and other subscription contracts.

STOCK REPURCHASE. Microsoft repurchased 20.4 million shares of Microsoft common stock for about $2 billion. They rolled their "put" warrants outstanding upwards and outwards. At the end of the quarter they had 30 million "put" warrants with strike prices ranging between $69 and $78 per share and maturities of 5-16 months. Life-to-date, they have collected about $305 million of "put" warrant premiums.

CASH. Cash flow from operations set a new high in the third quarter by exceeding $1.6 billion. This was up from $1.2 billion in the second quarter and from $892 million in the third quarter last year.

FINANCIAL MILESTONES. The company achieved several billion-dollar milestones including net income, which exceeded $1 billion for the first time. Revenues increased $1 billion for the first time and the company just missed hitting $1 billion of net revenues in OEM. The operating margin rose to 48.9% compared with 35.1% in last year's third quarter and 40.3% in the second quarter.

BUSINESS APPLICATIONS. Desktop applications revenues grew with the release of Office '97. They completed the release of this product in all of the tier one languages and results were particularly good for Office Pro in Japan and with corporate customers. Often when they have a mega-release like Windows '95, Office '95, etc. they see a spike, largely because of channel fill. With Office '97 they didn't see that kind of spike for many reasons. First, they were very controlled in their delivery of product to distributors and resellers so there was not an enormous amount of channel overfill. Second, they had unbelievably strong results in some of their corporate licensing programs and maintenance programs. So, unlike Windows '95 which saw a dramatic spike and then a relative tail, it took them several quarters to get that inventory through the channel, they think they have 6 or maybe a few more weeks of inventory in the channel depending on location. It is very lean, appropriate inventories and they had an enormous amount of corporate demand on license, rather than for product which suggests that there will be a long ongoing cycle of demand for this product. Front Page, Microsoft's web authoring tool, also showed strong results.

ENTERTAINMENT/ONLINE PRODUCT HIGHLIGHTS. The company's reference and entertainment titles were strong drivers of consumer software results. Hardware revenues for gaming devices were strong. MSN subscriber count increased to 2.2 million and released a series of new offerings this month. MSNBC also expanded and MSNBC interactive became "the most visited news site on the web" according to PC Meter and doubled the number of page views to 36 million. MSNBC cable grew it's sub count to 31 million, up from 21 million when it was launched last year. Sidewalk launched its first site in Seattle. Expedia, Microsoft's online travel service, was voted "the number one e-commerce site" by PCWeek magazine.

OPERATING SYSTEMS. Desktop operating systems results showed continued success for Windows '95 and Windows NT. Both benefitted from increased PC shipments and the shift to 32-bit operating systems as well as increased market shares. Total Windows '95 unit volumes grew compared to the prior quarter due to increases in both OEM and finished good units. NTW shipments increased more than 3 times over the prior year with 42% of licenses attributable to OEMs compared to 30% last quarter. NTW shipments were 11% of Windows '95 shipments. They think that they are seeing an enormous amount of demand for NTW in corporate settings. They also saw that for Windows '95 too. Before the 4.0 product was launched, there was hesitation in some corporations about which to choose -- NTW 4.0 or Windows '95. When NTW 4.0 came out, many customers bought that and also bought Windows '95. They think there is an opportunity goin gforward for increased NTW penetration as Pentium Pros and K6s roll out. But, there is also continued strong demand for laptops -- and laptops are running 35-40% of total PC sales for Windows '95.

BUSINESS SYSTEMS. Revenues in Microsoft's server and server applications business were almost double last year's quarter with the greatest growth in NT Server and the Back-Office bundle. The company released Exchange Server 5.0 at the end of the quarter, so no revenue was recognized in the third quarter. NT Server represents about 40% of the revenue in this area.

INTERNET CLIENT TEAM. Internet Explorer's market share increased to about 30%, up from 12% last quarter. Windows '95 customers, international customers, and the conversion of AOL subscribers were cited as the primary drivers of the market share growth.

DEVELOPMENT TOOLS. Microsoft released several new development tool products including The Visual Studio Tool Suite and Visual Internet Web Application Development System, with new versions of Visual Basic, Visual C++, and Visual J++. All of these products broke prior monthly sales records in March. Microsoft tools now represent more than 70% of all professional development, paced by over 3 million active Visual Basic programmers worldwide. The company said that recent surveys indicate that Microsoft Visual J++ popularity is soaring within the Java community.

RESULTS BY CHANNEL. OEM royalties hit a new high with revenues of $960 million, a 52% increase over the third quarter last year. The US and Canada finished goods channel revenues were $930 million, up 51% over the same quarter last year, largely due to the successful launch of Office '97. Microsoft announced strategic alliances with Hewlett-Packard, Ernst & Young, and key enterprise support vendors in order to strengthen their offerings for "mission-critical solutions." The company indicated that they have made progress in "enterprise support" and now have more certified professionals than Novell worldwide. Channel inventories appear good after the launch of Office '97 and Microsoft has fully reserved for areas that may be excessive.

RESULTS BY GEOGRAPHY. European revenues were up 44% to $799 million and were fueled by Office '97. Other international revenues were $511 million, up 29% over the same period last year. The growth was slower due to economic weakness in Australia and Korea. Microsoft was hedged against most of the dollar's upward movement but said that they will be negatively impacted in future quarters as they roll their hedges.

OUTLOOK. Fiscal 1998 will be a very tough comparison with 1997 due to "slowing revenue growth and increasing margin pressure," according to the company. This will be true even if PC unit run rates continue at this year's phenomenal level.

PRODUCT CYCLE-RELATED SLOWING. They company expects to experience slowing revenue growth and increasing margin pressure from a Microsoft product cycle standpoint, particularly for their largest revenue businesses (Windows and desktop applications). Windows '95 upgrades achieved 30% penetration of the installable base in the first 20 months. By comparison, when Windows 3 upgrades hit 30% penetration, they began slowing down, so the company expects '95 upgrades may follow the same pattern beginning next quarter. Memphis revenues aren't expected until the middle of fiscal 1998 which also leaves an upgrade flat spot in fiscal 1998. They expect OEM run rates to look the same next quarter, and are anticipating that the typical seasonal PC unit peak may move later into the year for OEMs. Benefits from NT workstation revenue mix shifts are not expected before late fiscal 1998 as well. The next major upgrade to the Office product suite won't come until fiscal 1999, so they expect those revenues to fall off after the June and September quarters, leaving fiscal 1998 flat. NT and Back Office are expected to continue to grow but, with Windows and Office revenues expected to flatten out, growth will be more dependent on the server business which suffers from concerns about the NC, cost of ownership, and scalability.

ECONOMIC CONDITION-RELATED SLOWING. From a geographic standpoint, the company expects to see slowing revenue growth and increasing margin pressure due to worldwide economic conditions and a strengthening dollar. The US, Europe, and Japan had an incredible March quarter. Europe and Japan face difficult general economic issues which "dictate caution in near-term expectations" since Microsoft's growth rate is increasingly dependent on enterprise purchasing cycles. They expect some falling off in June due to economic conditions on top of the general seasonal softness in the Summer quarter. Foreign exchange rates are growing in importance in shaping fiscal 1998 revenue expectations. Because Microsoft hedges against foreign currency translations to dollars a year in advance, they convert currency at the prior year's rate. This delays negative impact by a year, so while they haven't seen a big impact over this past year, they will next year. Next year, they won't be surprised if their revenue translation, hedged at current higher dollar exchange rates, isn't somewhere in the vicinity of $350 million less than it would have been if they could have hedged at the earlier rates they used for 1997, which is what is reflected in their current operating results. These exchange rate differentials also create price pressure in local geographies.

OPERATING EXPENSE-RELATED SLOWING. Finally, they expect to see slowing revenue growth and margin pressure from an operating expense standpoint due to continued R&D and increased sales and marketing spending. Their expectation is that product costs as a percentage of sales will be the same next quarter as this quarter, but it is mix sensitive. Their mix was about 60% licensing in the March quarter which was up from December but is probably indicative of what to expect for the next two quarters. R&D should continue to grow every quarter. They expect sales and marketing expenses to be lower next quarter because they won't have the Office '97 launch costs and support should be lower. Sales and marketing expenses are expected to increase in fiscal 1998 as a percentage of revenue, but they are still working on the plans. They expect general and administrative expenses to remain under control, barring unexpected things.

STOCK BUYBACK. They continue to be concerned about balancing the need to retain cash for strategic investments with the dilutive impact of their employee stock options which represent a $20 billion overhang. To offset this, they expect to continue to buy back shares throughout fiscal 1998 and will take advantage of dips in the share price whenever possible. Other income and expense should stay at about its $50 million per quarter run rate.

REVENUE EXPECTATIONS. They expect the likely fulfillment of the $190 million of unearned Office coupons to result in next quarter being flat compared to this quarter. In the first quarter 1998, they expect traditional slowness to be accentuated by factors mentioned earlier and it, therefore may be down sequentially from the fourth quarter of fiscal 1997 (June). After that, they expect sequential quarterly revenue growth to resume in December, but a moderate increase.

WEBTV DEAL. In the quarter that they close the WebTV deal, there will be a one-time non-deductible writeoff of about $300 million. This will reduce earnings per share by about $0.20 per share. After that, the transaction will be nominally dilutive for another year or so by a penny or two per quarter. The traditional up-front writeoff of in-process R&D as well as the subsequent amortization of the remainder of the purchase price are not tax deductible. So, after the close, WebTV's immaterial operating results will be added to Microsoft's and the main thing people will notice is that Microsoft's effective tax rate which is now 35% will go up to about 36% because of the non-deductible charges. Microsoft's goal for WebTV is to help them accelerate their product launch for the holiday season of 1997. They are a few months away from needing to produce the boxes to fill the channel to make the holiday season. They don't expect major changes in the product between now and then.

* A Fool conference call synopsis represents an effort to highlight the salient points of a conference call and should not be taken as an authoritative accounting or transcription of the entire event. Note: Statements made by a company other than historical information may constitute forward-looking statements for which the company can claim protection under the Safe Harbor Act. Please consult the company's filings with the SEC for information on risk factors which might cause actual results to differ materially from the information contained in these forward-looking statements.