微軟 (MSFT) 2009 Q2 法說會逐字稿

Welcome to the Microsoft fiscal year 2009 second-quarter earnings call.

Today's call is being recorded.

If you have any objections, you may disconnect at this time.

I would now like to turn the call over to Mr.

Bill Koefoed, General Manager, Investor Relations.

Sir, you may begin.

Thank you, operator and thanks to everyone for joining us a little earlier than normal today for Microsoft's second-quarter 2009 earnings conference call.

We decided to align the timing of the earnings release this quarter with the cost-management initiatives that we announced this morning.

We will talk further about these initiatives later on the call.

I am delighted today to be joined by Steve Ballmer, our Chief Executive Officer; as well as Chris Liddell, Senior Vice President and Chief Financial Officer; Frank Brod, Corporate Vice President and Chief Accounting Officer and John Seethoff, Deputy General Counsel.

The format for today's call will be as follows.

Chris will summarize some of the key takeaways for the quarter, as well as address the announcement we made this morning.

I will then provide details around our second-quarter results and then hand it back to Chris for a more detailed discussion of our business outlook and then Steve will make some comments.

After that, we will take some questions.

Please be aware that we filed our Form 10-Q today in conjunction with our earnings release.

We have also posted our quarterly financial summary slide deck, which is intended to follow the flow of our prepared remarks, as well as provide a reconciliation of differences between GAAP and non-GAAP financial measures that we will talk about today.

You can find these documents at the Investor Relations website at www.microsoft.com/msft.

Today's call will be webcast live and recorded.

Please be aware that if you decide to ask a question, it will be included in both our live transmission, as well as any future use of the recording.

A replay of the call will be available at the Microsoft Investor Relations website through the close of business on January 22, 2010.

This conference call report is protected by copyright law and international treaties.

Unauthorized reproduction or distribution of this report or any portion of it without the expressed permission of Microsoft may result in civil and criminal penalties.

We will be making statements during this call 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 today's earnings press release, in the comments made during this comment conference call and in the Risk Factors section of our Form 10-Q, our most recent Form 10-K and other reports and filings with the Securities and Exchange Commission.

We do not undertake any duty to update any forward-looking statement.

And now, I will turn the call over to Chris.

Thanks, Bill and again, thanks to all of you for accommodating our timing changes.

Our second-quarter results reflect the difficult environment as the global economy continued to deteriorate beyond our expectations, particularly during the month of December.

Despite this economic backdrop, we were able to grow revenue and utilize accelerated cost reductions to offset the majority of the impact of the revenue shortfall on operating income.

On a segment basis, our client business being the most severely impacted by the softening economy, declining 8% due to the significant weakness in traditional PC market sales, partially offset by the rapid growth of netbooks.

Revenue from Microsoft Business division and Server and Tools divisions grew a combined $500 million or 7%, driven by healthy demand from enterprise customers while the transactional aspects of these businesses were impacted by lower PC and server hardware unit sales.

Our online services business revenue was flat, although our online advertising revenue was up 7% in a tough environment.

The Entertainment and Devices division delivered revenue above the high end of our guidance, driven by a record number of consumers purchasing Xbox 360 consoles during the holiday season.

Against the backdrop of a deteriorating economy, we are focused on the need for fiscal discipline and on executing in the areas we can control by managing expenses while delivering on the next wave of our product pipeline.

During the second quarter as the economic outlook continued to slow, we accelerated our expense reduction plan.

These actions allowed us to deliver operating expenses in the second quarter $600 million below our October forecast.

However, today, we have also announced steps we will take to further manage our cost structure.

These steps include a reduction in headcount-related costs, including plans to reduce up to 5000 positions in the areas of research and development, marketing, sales, finance, legal, human resources and IT over the next 18 months, of which 1400 are effective today.

There will be no pay raises next fiscal year.

We have plans to significantly reduce our vendor and contingent staff expenses.

We will also be looking for reductions in marketing expenses, reduce capital expenditure and facility costs, as well as tighter discretionary spending, including significantly reduced travel-related expenses.

The cumulative results of these actions taken during the quarter and those announced today will result in operating expense savings of $1.5 billion and capital expenditure savings of $700 million lower in this fiscal year '09 than assumed in our July guidance.

Lastly, we plan to manage operating expenses broadly flat in fiscal year '10 and capital expenditure to be lower year-over-year.

While we are managing our expenses tightly, we continue investing in key strategic opportunities, which will fuel the future growth of the Company.

We have a strong product pipeline and are bringing to market a number of significant product releases over the next two calendar years.

With those high-level themes, I will turn the call over to Bill for more details on the second quarter.

Thanks, Chris.

I will discuss top-line financial and business momentum points followed by revenue performance for each of the business units.

Then I will review the rest of the income statement.

All growth comparisons relate to the comparable quarter of last year unless otherwise noted.

Revenue grew 2% to $16.6 billion, which was below our low-end guidance as the economic environment weakened further than we expected, particularly in the month of December.

Our mix of product billings was approximately 30% from OEMs, 25% from multiyear licensing agreements, 20% from license-only sales and the balance from our other businesses.

Despite the broad economic weakness, the annuity portion of our volume licensing business remains healthy and increased one percentage point in our billing mix.

Enterprise agreement renewal rates were in line with historical trends.

Unearned revenue grew over 7% to $13.1 billion, but was down sequentially.

Our contracted not-billed balance increased 10% year-over-year, but was slightly down on a sequential basis remaining at over $13 billion.

When taken together with reported revenue, total bookings for the Company declined 10% this quarter, reflecting the general economic weakness, primarily in our non-annuity business.

Overall, changes in foreign exchange rates added about one percentage point to our revenue growth.

Now, I will provide revenue details by business segment starting with Windows Client.

Client revenue declined 8% to $4.0 billion.

I will review the main drivers that contributed to this performance beginning with an overview of the PC market.

We estimate that the PC market for the quarter was approximately flat year-over-year, well short of our forecast of 10% to 12% growth, as the PC market weakened much more quickly and severely than expected.

Adding a bit more color, traditional PCs declined almost 10% with weakness in both consumer and business PCs.

This was partially offset by incremental growth from the new netbooks category.

During the quarter, our Windows OEM license units declined by 1%.

OEM revenue was 12% lower year-over-year, driven primarily by the dynamics of the underlying PC market.

Specifically, the decline in traditional PC sales drove double-digit declines in business and consumer premium SKUs.

This impact was partially offset by strong growth in our netbooks offering.

Our attach rates were under pressure during the quarter, but we didn't experience a material change versus historical rates.

Our netbook attach rates now exceed 80% as customers are clearly opting for the value Windows provides.

We estimate that we lost about two percentage points of growth due to the channel holding a lower than historical level of inventory.

The commercial and retail portion of the Client business grew 19% as it benefited from continued adoption of Windows Vista in the enterprise.

On the product front, our engineering team reached a major milestone with the delivery of the public beta of Windows 7, which has received great reviews to date.

We remain very positive about the Client product pipeline and its ability to drive long-term growth.

Server and Tools revenue grew 15% to $3.7 billion despite a declining server hardware market.

This achievement marked the business' 26th consecutive quarter of double-digit growth.

Annuity licensing continued to grow faster than non-annuity licensing.

The momentum of SQL Server 2008 and our Hyper-V virtualization helped drive Windows Server sales and increase our system center management tools attach rate, thus allowing us to grow our revenue per server.

As a result, Server and Tools continued to grow faster than the hardware market.

Demand for our consulting and support services to deploy Microsoft technology remains strong, driving revenue growth at 16%.

On the product side, the Server and Tools division made significant product development progress.

Released to beta, Windows Server 2008 R2 will add the live migration feature to Hyper-V, further enhancing our virtualization offering.

At the Professional Developers Conference in October, we provided a preview to Windows Azure, our cloud-based services platform.

The Azure services platform hosted in Microsoft data centers provides an operating system and a set of developer services that can be used to build new applications to run from the cloud or enhance existing applications with cloud-based capability.

Its architecture gives developers the choice to build web applications, applications running on connected devices, PCs, servers or hybrid solutions while using the same tools they use today.

The online services business revenue was relatively flat at $866 million.

Online advertising revenue grew 7%.

Search revenue grew double-digits while display revenue grew slower in a weak ad spending market.

We continue to see healthy growth in our traffic with page views and query searches both up on a sequential and year-over-year basis.

In the online services business, we recently announced important partnerships with Dell, Verizon and Sun Microsystems and released a new suite of Windows Live services.

We remain committed to the benefits that a strong online services business will bring to Microsoft.

Microsoft Business division revenue was up 1% to $4.9 billion.

Business revenue grew 7% driven by continued strength in the annuity business across Office, SharePoint and Client Access license suites, and benefited from strong deferred revenue recognition.

Non-annuity revenue declined on weakness in the midmarket, small to medium business and consumer segments.

Specifically, consumer revenue declined 23% driven by the weakness in the core PC market, a mix shift to lower-priced SKUs and inventory reductions from Q1.

From a product perspective, SharePoint, Office Communications Server and CRM all grew at double-digit rates.

We made significant progress against the product pipeline by releasing final versions of Exchange Online and SharePoint Online.

In October at PDC, we demonstrated our Office 14 Web applications, which will enable the rich and familiar Office experiences through the browser.

Entertainment and Devices division revenue grew 3% to $3.2 billion.

A record 6 million consoles were sold in the quarter, growing over 41%.

In Europe, Xbox 360 sales nearly doubled those of the previous holiday season.

Based on US NPD numbers released last week, Xbox 360 outsold PS3 2 to 1.

We continue to lead the industry with our software attach rate ratio of 8.1.

During the quarter, we also launched the new Xbox experience, which has been received extremely well.

This software update has given our customers a new upgraded experience that broadens its appeal and increases the value and durability of the platform to customers and Microsoft.

Xbox Live membership has grown 70% from last year to 17 million members.

Now for the rest of the income statement.

Cost of goods sold was $3.9 billion, increasing as a percentage of revenue two percentage points to 23.5%.

Cost of goods sold growth was driven by higher Xbox 360 console volumes, increased data center and traffic acquisition costs in the online services business, and growth in enterprise services.

Operating expenses were $6.8 billion, over $600 million less than was assumed in our low-end guidance.

This represents a significant slowing in the operating expense growth rate.

Savings included marketing, vendor, people, and general and administrative expenses.

As a consequence, operating income, which was $5.9 billion, was only $174 million below guidance, despite revenue being $712 million below guidance.

Other income and expenses was a loss of approximately $300 million for the quarter, driven by currency valuation declines on unhedged portions of the balance sheet and investment impairments, offset by dividends, interest and net recognized gains on investments sold.

Our effective tax rate for the quarter was 26%, half a percentage point lower than guidance, driven by an earnings mix increase in lower tax jurisdictions.

During the quarter, we repurchased 94 million shares or over $2.2 billion of Company stock.

We also paid out about $1.2 billion in dividends to shareholders.

Diluted shares outstanding were 8.9 billion, down 6.2% from the prior year as a result of the share repurchases.

Earnings per share were $0.47, representing a decline of 6%.

So as Chris noted earlier, the business environment made for a challenging quarter, but we feel positively about our quick response in managing expenses to mitigate the impact as much as possible.

With that, let me turn it back to Chris who will provide you with more insight into our business outlook.

I'm going to spend my remaining time talking about the balance of fiscal 2009.

Clearly, the volatility in the macroeconomic climate created a great degree of uncertainty in the second half of our fiscal year and in particular, conditions progressively worsened throughout the second quarter creating a broader than normal range of possible extrapolations looking forward.

So given that we expect macroeconomic conditions to be the most important variable in predicting our results in the second half, we are not providing quantitative revenue or earnings per share guidance at this time.

We will, however, provide you with the framework to help you think about the drivers for our business.

I will start with revenue beginning with Client.

The PC market is clearly the key driver for Client revenue and it is likely to remain weak over the second half of our fiscal year with market trends similar to or potentially weaker than the second quarter, especially in the traditional PC market, excluding netbooks.

Offsetting that partially, the netbooks mix of total PCs will likely follow similar trends to Q2 with continued strong Windows attach on netbooks contributing to overall Windows revenue.

However, as the economy slows, continued inventory contraction and pressure on attach rates would negatively impact revenue growth in the second half.

So overall, we expect Client revenue to perform broadly in line with the traditional PC market.

For the Microsoft Business division, I will stick to the three main drivers of the business.

Consumer revenue, which makes up about 20% of the divisional revenue, will be impacted by the declines of the traditional or non-netbook PC market, in addition to further channel inventory contraction.

Transactional licensing sales to Business customers, which make up about 25% of the divisional revenue, should generally align to the business PC hardware markets, which may continue to decline in the second half.

Finally, the remaining annuity licensing portion of NBD revenue, which makes up approximately 55%, is likely to remain somewhat insulated from macro trends and grow faster than IT spending due to the strength of the businesses like SharePoint and Unified Communications although it could face pressure due to lessening sales cycles.

The Server and Tools segment has many of the same drivers as the Business division.

The OEM and transactional licensing business customers, which is approximately 35% of the business, should generally align with the server hardware markets, which third-party analysts expect will decline over the second half of the year.

The remaining annuity licensing and enterprise services portion of the business will likely continue to grow faster than IT spending based on the strength of our product, portfolio and business model, but also could face some pressure due to lengthening sales cycles.

OSB revenue should follow similar trends to what was experienced in the second quarter as advertising spending will likely remain weak until the economy starts turning.

This is particularly true for the display advertising portion of our business where we expect monetization rates across the industry to continue to worsen.

Also, keep in mind that ongoing expected declines in our access business will weigh on the overall growth of the segment.

Additionally, we would expect a headwind from the impact of foreign currency in the second half of the year given the high proportion of revenue that comes from international markets.

The Entertainment and Devices division is highly dependent on consumer spending and while we feel good about the first-half results, a shrinking consumer spending environment would weigh on the segment's results in the second half.

Console revenue will likely decline as a result of our earlier pricing actions.

Attach revenue may also slow due to contracting consumer spending and moderating attach rates.

The other software and peripherals portions of our business follow the underlying PC market in the second half.

With that framework to assist our revenue prospects, let me move to our outlook on expenses.

The economy has clearly deteriorated more than we expected and we have responded to this environment by taking further actions to reduce expenses and to prioritize our efforts.

We have initiated a number of cost savings, which will layer in progressively over this fiscal year.

As a result of these actions, we now expect fiscal '09 operating expenses of approximately $27.4 billion.

Going forward, we expect to maintain our operating expenses broadly flat in fiscal year '10.

Moving to the other drivers of earnings per share, we continue to expect an effective tax rate of 26.5% for the year.

Other income may be negatively affected by further market movement.

We remain committed to returning capital to shareholders through stock repurchases over the long term.

However, given the increased uncertainty in the current market, our repurchase activity will slow in the second half of fiscal year '09.

With those overall comments and outlook, I'd now like to hand the call over to Steve so he can share his perspective before we take your questions.

Thanks, Chris.

We are certainly in the midst of a once-in-a-lifetime set of economic conditions.

The perspective I would bring is not one of recession.

What I would say rather is the economy is resetting to a lower level of business and consumer spending that is based largely on the reduced leverage in the economy.

Consumers can not refinance their homes, don't have that extra money to buy discretionary second and third PCs.

Business, in the business market, we certainly see a reduction in capital expense based upon lack of leverage and business conditions.

IT spending represents about 50% of US business capital spend and so neither the consumer nor the business side of the technology industry is immune to these economic -- to these economic conditions.

As a participant in the market that at least in some areas like our Client business has a very significant marketshare, you certainly feel the overall market impact most clearly.

In these times, I think there are three things to focus in on and not surprisingly, two of them are very similar to things we focus in on everyday.

The three things are, number one, innovation, which I will talk about.

Number two is marketshare, because even in a market that is suffering, share increases drive revenue growth.

We are always focused on share, but particularly now.

And number three is efficiency and effective resource prioritization and allocation, which is where I want to start and one where perhaps we have spent a little less time with you historically.

We are long term and I will come back to this -- we remain incredibly positive on Microsoft, the technology industry, the opportunity for innovation and yet now it is certainly the time to ask critically which of our investments should he prioritized and how can we get more efficient, get the same amount of work done, if you will, for less.

And we have been through an exercise and continue through an exercise looking at work processes and driving for efficiency, rightsizing and prioritizing some of our investments.

And we have had to take a number of actions.

We are taking a number of actions to, in some senses, manage our cost base.

Our cost base has grown, as many of you know, significantly over the last few years.

And while as Chris said we don't plan on shrinking it in FY '10, we are really putting the brakes on at a new level and quite significantly putting the brakes on.

With that said, we are going to continue to invest in important areas of opportunity and so even while we take out up to 5000 jobs, we will also be adding a few thousand jobs back in the areas like search where we continue to see incredible opportunity to do good work.

So we will take out, put back in, but in aggregate manage expenses consistent with the comments Chris had a chance to make.

In terms of marketshare, I think we have some great opportunity.

Bill talked about the performance of Xbox.

We sold over 5 million Windows Mobile units this quarter, which was great.

We got a lot of opportunity in search, but we're glad to have search volume up so significantly for us this quarter.

Our Server and Tools business reflects our ongoing marketshare improvements basically in both Windows Server and in our SQL business.

You will see us continue to invest, particularly in Web servers and technical computing as we move forward.

In the Client business, we sold north of 50 million units of Windows, had another big chunk unfortunately that probably got used, but not paid for and yet we lost maybe a point of share as Apple sold 2.5 million Macs during the same period.

We have big plans there with Windows 7 and everything that we have coming forward.

And certainly in this economic climate, the kind of price premiums that people pay for Macintosh versus PCs I think will be looked at far more critically by customers as a number of reviewers have started to note.

In the case of netbooks, we have gone from no share to, as the guy said, over 80% share and climbing and it is a whole interesting topic in and of itself.

Our Office business with the consumer market, volumes are up dramatically year-on-year, over 14%, which is a business people think where we have high share.

We have great opportunities.

So a lot of focus in in the enterprise space, in the online space, in the entertainment area and the client area.

We had a lot of opportunity to work on marketshare both from a product development standpoint and from a sales and marketing perspective.

Our product pipeline and the work we are doing in innovation I am excited about.

We have had first looks on Windows 7.

We have had good market reaction to Windows Azure, new version of Office, Office 14.

I am excited to be out in the next year or so, Windows Server 2008 released too, builds on the strength of Windows Server.

We have certainly got our work cut out for us.

There are businesses where we have got a lot of work to do where we don't have leading positions and there are some businesses where we have got leading positions.

We just have phenomenal new products to come.

But we will continue to invest strongly in R&D.

That gets very well-funded in the operating expense strategy that Chris talked about, but at the same time, we are prioritizing, we are focusing on the most important stuff as we go forward.

Certainly while the size and scope of this economic dislocation is unprecedented, it may delay technology adoption in the industry at large.

I don't think there is any stopping the forward march of our industry or of Microsoft.

And in the long run, let's call it the pause that the economy is imposing on our industry, will certainly just be that.

It is a pause and there will be renewed strong growth in the technology industry overall and certainly at Microsoft.

And we will focus, we will focus on efficiency, on marketshare and on innovation as we drive forward and with that, I'm going to hand things back over to Bill so we can start taking some of your questions.

Thanks, Steve.

Let's now proceed to questions.

We want to accommodate questions from as many people as possible, so please avoid multipart questions and I will strictly limit you to just one question.

Operator, will you please repeat your instructions?

(Operator Instructions).

Brent Thill, Citigroup.

Thanks, good morning.

If your fiscal '09 guidance holds, this would be the fourth consecutive year of operating margin decline.

Do you think you're taking quick enough action to realign the business to this lowered demand environment?

Yes, we believe certainly taking, as you saw, $600 million worth of costs out in the second quarter, which is almost 10% of our cost base for the quarter, was very prompt action.

And if you look at $1.5 billion for this year as well, we believe in the context of a deteriorating economy that really accelerated in December.

So we are talking about reacting to the last in particular month to six weeks or so of economic data.

We think the actions we took were actually both very fast and appropriate for that now.

I agree with the margin comment, but clearly also the mix of our business is changing quite significantly as well.

So as we sit here today, based on the facts that we have seen, in particular over the last few weeks, we think we have taken the right degree of action in terms of reducing the cost base, but continuing to still invest against the revenue that we see coming forward.

I think the one thing you have to understand is with our margin structure, i.e.

with high margins as a percentage of revenue, we are going to be far more volatile both on the upside and on the downside to fluctuations in revenue.

And unlike a company that is sort of more about manufacturing where everything kind of scales with volume, we have a much larger fixed cost chunk.

And on the upside, when revenue goes strong, it's a chance to increase margins, but when revenue is weaker, it is likely that margin percentages will decline.

And when you look at the initiatives we have taken, depending on the item you are talking about whether it is from people to things like travel expenses to vendor costs, we are taking out somewhere between 5% and 15% of the cost line that we are talking about, which we think, in this environment relative to the reset in the economy, is probably the right level.

Thanks.

Next question.

Heather Bellini, UBS.

Hi, good morning.

You mentioned that you are laying off 5000 people.

I am wondering if all of those are Microsoft employees or are there also outside contractors that work at Microsoft that you are not including in that total.

And I guess along that line, are you including cash severance charges that you are going to take for the reductions in force?

Are you including that in your operating expense guidance for fiscal year '09?

Thank you.

Yes, Heather, the outside contractors are not included in that number and we will be certainly looking to reduce that cost line probably in proportion by more than what we are talking about in terms of internal people.

So the 5000 jobs we talk about are entirely Microsoft-related.

Let me make sure the math is clear.

We may eliminate up to 5000 jobs, but we are also adding a few thousand jobs.

Yes, I think we all assumed that, that net net, it's going to be less than 5000.

And we are talking here now primarily about operating expense headcount as opposed to cost of goods, which varies in its own criteria.

So on the operating expense line, I expect this to be down more like a net sort of 2000 to 3000.

Right.

But then to Chris' point, it looks like you'll end up cutting more outside contractors than the 5000 or than the 2000 to 3000 you just mentioned?

Yes, those numbers are all internal people, Heather.

External contractors I guess we think about more in terms of the dollars that we spend overall, but that could be down -- that is on top of the numbers we are talking about and that could be down up to 15%.

Okay.

And then the cash severance charge part?

The cash severance charge is not included in the operating expense that we are talking about.

It will not -- we are looking at the numbers and obviously it depends on the final number that we talk about with people, but we will call that out separately in the third quarter for the 1400 people that we are talking about today.

And then I guess as other people leave the Company, we will look at the charge at that time.

Okay, thank you.

Let's move to the next question, please.

Adam Holt, Morgan Stanley.

Good morning.

My first question is about the buyback.

Is the slowing of the buyback activity principally related to just capital preservation, or do you see an opportunity to maybe be more aggressive on the M&A side given some of the depressed valuations?

And then just secondarily, can you walk us through maybe even some high-level thoughts on how you view the PC market?

I know you're not giving explicit guidance, but what your expectations are for piracy?

Any just kind of guidelines for how we should be thinking about PC growth for the back half of the year?

Thanks.

Sure.

On the buyback, it is both the factors that you mentioned.

Certainly capital preservation in this environment is more important than it has ever been.

On the acquisition side, clearly the opportunity to buy shares is very good in Microsoft.

Having said that, the opportunity to buy other companies has probably never been better relative to their price as well.

Having said that, I wouldn't expect M&A activity to be particularly significant in the second half of the year, simply because I don't think the market generally has yet lowered their expectations to the new level of prices we are talking about.

So we will continue to buy some small, medium-size businesses as we normally do.

Prices are certainly coming down, and that is an opportunity from our point of view.

But I think the level of activity will be relatively low certainly in the next quarter or two, but the opportunity there afterwards to buy companies, again, generally speaking the small and medium-size, I think is going to be very good.

And that is part of the thinking about why we are trying to retain our capital and retain our powder as much as possible.

On the PC market, you're right, we are not giving guidance.

I gave some directional thoughts.

We aren't projecting -- and clearly macroeconomic rather than Microsoft specific factors are really going to drive the PC market over the next six months.

But you have to say realistically, the base case is for a continuation or even possibly a slight deterioration from the second quarter in what we describe as the traditional PC market.

It is worth remembering that the market has -- let me just say broadly speaking -- four pieces to it.

Business PCs, of which we receive our highest royalty, consumer PC, netbook, netbook PCs, and then let's just say everything in emerging markets, of which China is half of that.

I mention that because we have different pricing in each, and we have -- particularly in the last one, we have some high piracy dynamics which affect it.

The PC market overall is probably strongest today in emerging markets, the second strongest in netbooks, third strongest in home PCs, and weakest in business PCs because that is where -- it is a place where businesses will say we will just extend the refresh cycle some.

So our economic drivers don't look like overall PC market; they look like the components.

And unfortunately, right now, we are in, let's say, a tough wind relative even to that mix.

Adam, the other thing I will say, and I think this is generic to all the businesses, is we saw quite a different shape in the quarter December, particular, was relatively weak inside the quarter.

October, trading conditions were, generally speaking, in line with our expectations.

The first half of November was and we like to think most companies out there saw the weakness really start to sit in late November and through December.

So to some extent, it depends on whether you extrapolate the quarter overall or the conditions that we and most companies saw in December as to what sort of environment you see in the first half.

And that creates, if you like, the bookends of expectation, but those are quite wide.

If you extrapolate the quarter overall or extrapolate December, you get quite different answers and that is true of the PC market, it is also true for the business overall.

Good color.

Thank you.

Let's move to the next question.

Sarah Friar, Goldman Sachs.

Good morning, thanks for taking my question.

Just to follow up there on the PC growth rate versus Microsoft's growth rate.

Steve, I understand your point about you are oriented away from -- maybe you don't make as much money on some of the segments that are growing fastest.

The delta we saw this quarter, effectively about 8%, is that a reasonable delta to think about going forward?

Particularly, you have a sense of how inventory noise was in the quarter.

Does that die back and maybe close that delta or should we keep thinking about it at about an 8% delta?

I don't know think you can pick a magic number because the dynamic -- unfortunately the dynamics shift fairly quickly.

My guess is wherever businesses are going to reset that will reset more quickly than where the consumer will wind up resetting to.

The consumer will be more volatile.

Our business customers will go through one round of thinking, rethinking budgets and then they will reset at a new level.

And so I think we are going to see more dynamism unfortunately in that number.

Yes, Sarah, I'll add a little bit of color to that and there are more, as Steve says, there are more moving pieces this quarter than there are normally, but if I try and simplify it a little bit, if you take what we have described as our traditional PC market, which is a mix of the business and consumer that Steve just mentioned, and take that as one growth rate, netbooks will clearly grow in excess of that and give us a little bit of a revenue uplift.

We will see probably some inventory contraction.

Attach rates on average are probably going to be much the same.

We might lose some in the traditional market, but a gain a bit on the netbooks side.

And then we'll see our traditional shift to emerging markets.

Although interestingly, they have slowed more than traditional markets inside the quarter.

You throw all of those things together and we would expect our revenue in Client to be broadly in line with the growth rate from the traditional PC market.

So all the other pluses and minuses will, generally speaking, cancel themselves out.

But not as big a delta as we saw this quarter?

Relative to the PC market -- in fact, we saw -- it is about the same.

So the traditional PC market we think shrank somewhere between 7% and 10% in the quarter on average and our revenue for the Client business was down around 8%.

So in that range.

So that sort of trend, based on the set of factors which, as Steve mentioned, are moving quite quickly, but if they hold relative to the second quarter, you're probably going to see that same overall trend in the back half.

Helpful.

Thank you.

Thanks.

Operator, next question.

Kash Rangan, Banc of America.

Hi, thank you very much.

Steve, since we have you on the line, just (inaudible) ask you a question on the headcount reduction.

You pointed out that the consumer spending and business spending has contracted pretty sharply and yet we are talking about a 5000-person headcount reduction here.

It still leaves the operating expenses for this fiscal '09 up about 10% despite the revenue growth of what looks to be about a percent or so.

So I am wondering what your thoughts are -- what are your assumptions?

It looks like you are factoring in some sort of a rebound, maybe 12 months, 15 months.

Certainly you don't want to lay off a lot of people if you end up having to hire them back when the economy starts to turn.

I am just wondering if that is the way you're thinking about it or are you actually open to revisiting the cost structure if indeed the economic conditions continue to act the way that you portrayed, that is a vastly lower level of consumer and business spending on technology?

Are you open to another round of cuts if you have to (inaudible) the OpEx in line with net revenue growth that we're looking at in '09 and '10?

Well, no.

I would say actually a couple things.

I don't know about that.

We are not used to downmarkets.

So PC market, the traditional market, as Chris calls it, was down 7% -- whatever it is -- 8% or so.

8% is vast for something that has always grown a lot, so maybe some of your adjectives I would modify slightly.

We are certainly dealing with unprecedented ground.

Our model is not for a quick rebound.

Our model is things go down, as I said, and they reset.

The economy shrinks and then it doesn't rebound, it builds from a lower base effectively.

So that kind of built in and our work on costs overall reflect that model.

So no, I am not expecting a [balance] and when we did our resizing, we did our resizing with an eye both towards margin, total profit, shareholders, short-term and long-term investment in the growth opportunities that we see.

So no, I would say that if the economy stays down and then builds slowly, we are probably at about the expense base and we will stay at about the expense base that Chris talked about.

You can't tell.

The economy could also get a whole lot worse.

It could get a whole lot better, but our basic view is that things go down, stay down for a while, years, a year, two years.

I don't know what it will be and then start to build back again.

That is kind of the basic planning model behind this resizing of our cost base.

You could say that means you could see lower total profit percent margins and that is certainly possible.

Next question.

Philip Winslow, Credit Suisse.

Hi, guys.

Just wanted to dig into the severance charges for a minute.

You mentioned that you are including those in your GAAP OpEx guidance.

What level would you expect that to be in the second half of this year?

I said just to be clear that this wasn't in the number 27.4 that I mentioned, so it would be on top of that.

And we would expect it to be several tens of millions, but less than $100 million to give you an order of magnitude.

And it is going to depend entirely on the number of people that we talk about and the individual circumstances.

So I can't give you an exact number, but that is the order of magnitude.

Next question, operator.

Brad Reback, Oppenheimer.

Hey, guys, how are you?

Good.

I am a little confused.

Chris, as you talk about, on the share repurchase side, slowing it down in the second half of the year, but on the other side, only talking about $1.5 billion of costs coming out over the next 18 months, I mean clearly it is full of very valuable franchise with a lot of cash flow.

Why not take this opportunity to buy back probably the best investment there is at least from your perspective?

My comments were certainly from the -- over the long term, we remain committed to the buyback activity.

The buyback activity in the first half was actually very high.

All I did was signal that we expect in the second half that we will moderate from that level.

Will we continue to be a net buyer of our shares?

Absolutely.

Do we think liquidity in the current environment?

Certainly until we get a clearer pattern on economic activity overall.

Is it a premium?

Yes I do.

Do I think there is going to be some outstanding opportunities over the medium term to potentially buy some of the companies that we have looked at?

I'll mitigate that by saying small to medium.

Yes I do.

So the opportunity cost of buying our shares has also gone up, as well as the price going down.

We are just trying to balance those factors, but we are certainly not talking about getting out of buyback activity as a general concept.

I will remind you there was a time when we tendered shares at $25 because they looked super cheap.

Of course, it is hard to know what the underlying market is going to do in asset values and we just think it makes sense to keep a little bit more liquid for a while.

But also and I have been consistent on this, we try not to tell you in advance what we are doing on the buyback activity.

We do it on a quarter.

All I am doing is giving you a directional trend.

Next question, operator.

John Difucci, JPMorgan.

Thank you.

Guys, can you just help me a little bit here in reconciling -- it's sort of a follow-up to some of the other questions -- because you are talking about the declining environment.

Actually meaning going down and the uncertainty going forward.

And you are resetting expenses to reflect this.

But your new guidance for operating expense is still up meaningfully in the second half year-over-year when you adjust for the third-quarter charge last year.

If you really think things are, and they obviously are, we all know they are tough out there and the data looks like it is coming down, it is getting worse year-over-year, but your expenses -- you are laying off some people.

No one likes to see anybody get laid off.

I'm sure you don't, we don't, but net 2000 to 3000 out of 91,000 or whatever you have, are you really -- are you really resetting expenses to reflect what is out there?

Bear in mind, of course, in the year, half of the year has already gone and we are reacting to a situation that, as I say, in particular is in the back half of the quarter.

So we -- (multiple speakers).

Yes, but this is year-over-year for just the second half.

Your expenses are still up -- your operating expenses are still going to be up if you exclude the third quarter last year, that 1.35 [fine].

So -- I am sorry.

Go ahead, Chris.

No, no, no, your point is valid and I'm very happy to address that.

Yes, what I describe it as is change in the momentum of our expense base going forward, but clearly we already have things in the pipeline and people who are our employed who we have to bear the expense of.

So we are talking about a plan that stretches out over the next 18 months as opposed to the next few months, of which the first few steps were taken in the quarter.

That is why we were able to reduce by $600 million, $1.5 billion over this year and flat the year afterwards and a program to reduce not only people internally, but the balance of initiatives that we took.

So these things are layering in over time and are in response -- you remember I talked about at the last call, we were taking a set of initiatives the next quarter and I said at the time, if things got worse, we would probably look to do more.

Things did get worse and we did do more, so we are talking about layering in as we see economic conditions change.

So yes, we would all like to be able to take things out instantaneously.

The reality is we can't do that as quickly as we would like, but you will see us take action that have impact over the next few months.

Operator, next question.

Todd Raker, Deutsche Bank.

Thanks, guys.

Chris, I was wondering if you would look at the overall corporation, could you give us a sense in terms of how kind of consumer versus transactional business versus annuity breaks out and what is the risk as we look at this spending environment that the annuity business starts to show some dramatic impact over the next kind of six to 18 months?

The annuity business was good in the first quarter and the second quarter, so that is certainly -- one of the strengths of our business model has been the relative insulation of our results as a result of the annuity business.

That is a very good point.

Non-annuity business shrank during the second quarter.

Annuity business actually -- the revenue associated with the annuity business actually grew, so it is providing us some degree of insulation.

And we are talking about results obviously that are lower than expectations.

Just keep that in context, we still grew revenue 2% in probably the worst environment that we have seen.

Part of the reason for that was the strength of annuity.

Over time, in particular if we see the business environment deteriorate in the second half, clearly that annuity business will slow.

Having said that, our annuity -- our re-signing rates inside enterprises was broadly in line with historic rates.

Billings were broadly flat in the annuity area year-over-year, so they aren't growing as fast as they were, but they weren't declining either, they were broadly flat.

We have a very big second half from a billings perspective, so they would have the opportunity to actually put some more money back in the bank.

So on that side of the business, certainly stronger historically and that will provide us some degree of cushion as we go through the next six to 12 months.

The way I would characterize it is it is a bit of a [dance] oscillation where we are actually recognizing now contracts signed two or three years ago.

The contracts -- we are re-signing contracts, but sometimes we are re-signing contracts with companies that have less employees, therefore they have less PCs.

So even if they are renewing their contracts, they may not be renewing at the same dollar value that the contract is expiring.

The effect of that shows up in unearned revenue and all that kind of stuff in the books, but from net income, it takes longer.

So if we stay in this cycle and there are fewer people employed in the US, eventually that does ripple through to the annuity business also.

But non-annuity is likely to be more volatile and more negative than the annuity, which is likely to provide -- as Steve said, it's slightly below the oscillation of revenue overall.

And any rough -- (multiple speakers)?

Sorry, what was that?

I was just trying to get a rough sense for the percentage of the business that is annuity-driven on an overall basis.

It changes a bit quarter-by-quarter because of things like Xbox, which is all clearly non-annuity and moves things, but generally there is between 30% and 40% of our revenue.

Okay, thanks, guys.

The annuity side is 30% to 40%.

Next question, operator.

Robert Breza, RBC Capital Markets.

Hi, thanks for taking my question.

Maybe, Steve, can you talk about, as you look at the portfolio of businesses you have, and obviously if we go through this economy the way it is, I mean when or if do you think you and the Board would take action to review your portfolio and make a strategic decision to possibly divest of certain assets or technologies?

Any color around the strategic thinking would be helpful.

Thanks.

I like our portfolio.

Okay.

The Board likes our portfolio.

Operator, next question.

And this will be our last question.

Katharine Egbert, Jefferies.

Hi, good morning.

So you said your (inaudible) buyback is to preserve capital.

You said no significant M&A in the back half because the sellers haven't reset their expectations and yet you are adding search jobs.

What are you really telling us here?

You are setting basically the status quo with Yahoo!?

I don't think we said anything about Yahoo!

I don't think we have anything to say about Yahoo!.

I think I've been quite public about the fact that I think there are advantages for consumers, advertisers, Microsoft and Yahoo!

through a search partnership and we'd like to do one.

I know Carol Bartz well from Autodesk days and glad to see her at the helm of Yahoo!

and if it's appropriate, I'm sure we will have the right discussion.

Just to be clear, my comment about resetting of expectations was certainly not Yahoo!-specific.

I think we are being quite clear that that acquisition is no longer on the books.

It was a more general comment and my prediction of lower activity in the second half was just a prediction and nothing more than that.

Clearly, we saw an opportunity in our -- as we do in terms of buying businesses, one or two a month and we'll take it.

I am just simply making the psychological comment that most people in a downmarket hope that they will get last year's price rather than this year's price.

We have only bought one thing ever over $1.5 billion and we have only bought three things over -- other than that over $1 billion.

We are not big M&A doers in general and as Chris said, I don't think even small M&A is tougher as people get or small, that is sub $1 billion, acquisition prices are tougher because people just don't know how to value their businesses today.

Sure.

Okay, thanks.

That will wrap up our Q&A portion of today's earnings call.

Thank you, everyone, for joining us this morning.

We look forward to seeing many of you in a few weeks when we will provide our annual midyear strategic update in New York.

Remember that you can access this call on the Microsoft investor central website at www.microsoft.com/msft.

Thanks again for joining us and have a good day.

That concludes today's call.

Please disconnect your lines at this time.