Steve Ballmer, Chief Executive Officer
John Connors, Senior Vice President, Finance and Administration, and Chief Financial Officer
Kenneth DiPietro, Corporate Vice President, Human Resources

Coordinator: Hello and welcome to the Microsoft conference call. At the company’s request, this conference is being recorded for instant replay purposes. At this time I’d like to turn the conference over to Mr. Mark Murray, director of Corporate Public Relations. Sir, you may begin.

Mark Murray: Thanks, everybody, for joining us. I appreciate the fact that for many of you you’re on deadlines so we’re going to keep the call very short and move right through it. I’m here with Steve Ballmer, our chief executive officer; also John Connors, our chief financial officer and senior VP for Finance and Administration; and also Ken DiPietro, who’s our vice president for Human Resources.

This call will be replayed and there will be an opportunity for questions and answers at the end of this call. So with no further ado, I’ll introduce Steve Ballmer to walk us through some of the compensation changes that we’re announcing today. Steve.

Steve Ballmer: Thanks, everybody. We appreciate your time. I want to spend a few minutes for you and set a context on how we’ve come to today, and what it is that we’re announcing to our employees here, as we speak.

Every company, I think, says a lot about people being its most important asset, and certainly in our business where the end product we sell is essentially just a bunch of ideas, a set of intellectual property, that’s absolutely critical. I would characterize people issues – retaining, attracting, motivating, and providing a framework of goals for the people – the most important asset of our company and is an important part of the management challenge here at Microsoft.

Over the course of the last several years it has been clear from input that we’ve been getting from our employees through our employee surveys, questionnaires, and polling that we’ve done of our employees that there was essentially a set of, what shall I say, anxiety or angst over our compensation approach.

We’ve taken time over the last few years, but particularly over the last 12 months or so, to really dig in and understand that input, to drill into it through additional surveying, discussion, and focus groups with employees. We set about the task of asking, “Is there a smarter way to compensate our people, a way that would make them feel even more excited about their financial deal here at Microsoft, and at the same time be something that was at least as good for the shareholders as today’s compensation package?”

Compensation is certainly not the number one reason most people work at Microsoft. That’s why I think, despite this level of angst, we’ve had great success over the last number of years, two or three years, in bringing in great talent from the outside and in retaining the talent that’s here today. But any wasted energy that goes into thinking about this stuff is energy that doesn’t go into thinking through how to do innovative work that helps people realize their full potential so we’ve taken this challenge on.

In this framework of saying how do we do better for our employees, and at the same time do at least as well by our shareholders, I think there were four key philosophical points that we had in mind, in addition. One, we had to make sure that our new compensation system would be helpful in terms of helping us attract the best people to Microsoft. It would have to be useful in retaining people through thick and through thin, if you will, after they join us. It should do all it can to help focus, from a goals perspective, our employees on the fundamental emotion that we want to have lots of customers, and that those customers should be very, very happy and satisfied with their interactions with Microsoft. We want to make sure that anything we do, not only has no negative impact to shareholders, but anything we can do that further aligns the interests of our employees, in the interest of our shareholders, that’s certainly a good thing from many, many perspectives.

The new program, which we’re announcing to our employees, has a number of elements. Most of these are in the release, but I want to go through them shortly. First thing is, effective this personnel review period, which we’re now in the middle of, we are phasing out stock options. There will be no new stock option grants from Microsoft. Instead, we will award actual stock to our employees. The stock will vest over time, just like stock options vested over time, over a five-year period, in our case. But when the stock award vests, the employee receives actual stock as opposed to options.

For our most senior people, which is a group of about 600 folks, they will have an opportunity, also, to earn additional stock awards. We call those shared-performance stock awards, and the basis of granting those will be a set of inputs that we will collect in terms of the number of Microsoft customers over a three- or four-year period of time and the satisfaction of those customers. Depending upon how we do on those measures, most senior people, the top 600 or so people, will get larger or smaller stock awards based upon that performance. Of course, those people are still tied into the success of the company and revenue and profit as those get reflected through our stock price.

The third aspect of the plan, and both of these things, I think, will help us from an attraction and from a retention standpoint. Employees will always have some long-term equity value to look forward to, which I think is good for alignment and good for retention and, frankly, good for attraction. People will have an opportunity to participate. If the company grows and succeeds, obviously, their financial situation improves with improvements in the stock price so, like the shareholders, they’re very tied into those key things.

The other thing which we are announcing to our employees today is the work that we are doing to implement a program that will allow them or give them the option, I should say, the choice, to sell their options that are, let’s say, quite a bit underwater, to a third party or a set of third parties. We are working through the details of that now, both with the Securities and Exchange Commission, who needs to review this kind of an offer, as well as with third parties. The goal here would be to allow the employees to make a sale of their underwater options, and to receive the proceeds from a third party on that sale on some schedule which vests into the future.

We think that helps with retention. It helps, again, with some of this angst that we have seen in our employee community, and it represents a great return to the shareholders. Since the shareholders had already granted those options, there’s no new cost, no new options, no new cash being used, and it allows us to solidify our important employee base, particularly, as we march forward over the next few years towards milestones like the next major Windows release and other key milestones for the company.

So those are really the core elements of the program. We do like the alignment with shareholders quite well. It’s a long-term plan. It lets the employee benefit with the long-term success of the company, an important dimension because we’re giving people stock instead of options. I actually think we will see stock ownership, as opposed to stock option ownership, grow in the company from our employees, which helps with alignment, and whether it’s dividend policy or how much risk to take in the business, it’s always good to have the employee base thinking just like the shareholders where that’s possible.

We’re enthusiastic about the changes that we’re making for our own company. We recognize our leadership position in the industry and people will look at this in that context, but we certainly respect that from a compensation perspective it’s not one size fits all in this industry. Different firms will do different things appropriately.

To implement this decision we needed to take a look at what the appropriate accounting treatment, the most sensible accounting treatment would be for our new stock award and shared performance stock award plan. We have elected to account under FAS 123 for this compensation program; it’s an election that we can make. It’s a sensible election, given that we don’t want to receive variable accounting treatment for some of the performance-based nature of the stock award.

Given that we are going to account for this under FAS 123, which is also the rule under which stock options must be expensed, it means we will also be expensing stock options that have been granted previously. For best comparability of our results going back and forward, we will reflect FAS 123 in our basic results for prior years in addition to our go forward results.

We’re not granting new stock options and, therefore, are not trying to make some grand statement about the appropriateness of that. We think different industry participants will see that differently and we respect that. But given what we’re doing with our new compensation plan, we will elect to account for this under FAS 123.

I don’t think that’s the big part of the news. The big part of the news here, really, is the reshaping of our compensation program in a way that I think gives us the infrastructure to let us get to the next level. We think the opportunities to change the world through the kinds of work that we do over the next ten, fifteen, twenty years are outstanding, and we want to make sure we have absolutely the best environment we can to attract and retain the innovative, clever, amazing people who are going to be able to build the software that really takes us to the next level.

With that, I’m going to end our opening remarks and turn things back over to Mark for the question and answer session.

Mark Murray: Thanks, Steve. Operator, we’re now ready to begin the question-and-answer period.

Coordinator: Thank you. Our first question comes from Jason Maynard from Merrill Lynch.

Jayson Maynard: This is a question for John. In terms of the reporting of the prior year stock options, can you just give us a little idea in terms of the level of detail by, let’s say, individual line-item on the income statement for the particular employee groups? Then going forward, how will that be reflected through the P & L and with each business unit?

John Connors: Thanks, Jason. We’re not going to get into numbers on the expense or P & L impact today. We’ll share that with you on the 17th, in our earnings call, as well as just get a chance to talk about it more at the financial analyst meeting on the 24th of July. In terms of historical expense, we’ve tried to be real clear what the impact of expensing options would be quarterly and annually. For those of you that aren’t familiar that are on the call, I would recommend you go to our 2002 10-K, footnote 15, and that gives you a view historically. We will, obviously, share that with you on the 17th.

Mark Murray: Operator, next question, please.

Coordinator: Our next question comes from Bob Austrian from Banc of America Securities.

Bob Austrian: Thanks. I have many, but I’ll try to keep to just a few. The first would be what is the implication of today’s news as it relates to currently approved or future possible buyback of common stock in the market, and how might it affect the rationale? Then, secondly, is there in any of this, Steve, a shift in Microsoft emphasis on cash compensation for employees versus equity things or equity related, be that options in the past or restricted shares in the future?

Steve Ballmer: Maybe I’ll take the second question first, and then I’ll let John comment about buyback, if that’s OK. In terms of shift in emphasis, I don’t see any real shift in emphasis. For senior people, the bulk of their compensation is still tied up in equity compensation programs, be that stock option programs before, or now the stock award program. For more junior people, there’s a nice hefty piece that comes from stock, but still the bulk of the more junior person’s compensation would come from cash. So there’s no philosophical change here being reflected.

John Connors: In terms of the buyback, Bob, we’ve been very focused as we’ve shared with you guys on managing dilution, and since December 31st of 2001, our fully diluted share-count has decreased. We’ll continue to be really focused on it, and I do think that the program allows us to have a good dilution management going forward. There’s nothing to talk about specific about the buyback today, though, related to this.

Steve Ballmer: No change.

Mark Murray: Thanks, very much. Operator, we’re ready for the next question.

Coordinator: Our next question comes from Brendan Barnicle from Pacific Crest Securities.

Brendan Barnicle: I had a question for John. If we look back historically, it looks like options have been about 4 percent that you’ve issued in terms of dilution every year. Is that what we should expect going forward with the stock awards that are put in place, basically, be getting the same number of stock awards as they had options historically, but just under a different formula?

John Connors: Going forward, because of the predictability and more certainty of stock awards, the absolute number of units would be smaller than options. What impact that has on the P & L will be a function of the stock price. We would not anticipate that the amount of equity given out going forward would be higher than historically and 4 percent would not be a number that we would anticipate.

Brendan Barnicle: Do you have a sense of a range yet or you want to wait on that?

John Connors: Yes. We’ll wait and talk on the 17th about what we think the fiscal year 2004 impact looks like.

Mark Murray: Thanks, very much. Operator, we’re ready for the next question. Given the shortness of time and the need for us to be communicating with our employees, we probably only have time for one or two more questions, maximum. So we’re ready for the next question.

Coordinator: Thank you. Our next question comes from John Markoff, from The New York Times.

John Markoff: Can you give us any guidance about the number of options that the average Microsoft non-management employee might hold, any way to quantify this and compare it to stock in the future?

Steve Ballmer: You mean hold or receive, John?

John Markoff: I’m looking for any way that a non-financial person could get some sense of what an average Microsoft employee gets.

Steve Ballmer: The way to think about it is there’s a range of stock prices at which the employee is better off with the new program, and there’s a range of higher stock prices where they would have been somewhat better off with the old program. Does that make sense?

John Markoff: That does, but I’m looking for a dollar accruement. Does the average employee own a hundred shares or get a hundred shares over time or how much have they gotten?

Steve Ballmer: There’s no average, unfortunately. The way I would tell you to think about it is for stock prices closer to the current stock price people will be under the new plan, 15 percent, 20 percent, maybe more, better off financially per year. For higher stock prices things start to converge, and you get the sum stock price, maybe they wind up being 10% to 15% less well off. It’s that kind of range if you compare the two approaches.

John Markoff: Thank you.

Mark Murray: Operator, do we have any other questions? We probably don’t have time.

Coordinator: At this time, Mr. Murray, I show no further questions. I would like to turn the meeting back over to you for any final thoughts.

Mark Murray: Thanks very much and thanks, everyone. We very much appreciate your jumping on the call with such short notice. A little housekeeping, this call will be replayed. The domestic call-in number is 888-568-0649 and the pass code is 1492. For international callers who want to get replay, the call-in number is 402-998-1536 and the pass code is the same, 1492.

Obviously, if you have any questions, please feel free to contact Microsoft Corporate Public Relations or Microsoft Investor Relations, and we’ll try to get those questions answered. Thanks very much, everyone.

Coordinator: Thank you very much for participating in today’s conference call. Have a great day and you may now disconnect.