HBR Case Study on the Transformation of Microsoft

9-218-048 OCTOBER 30, 2017

C. FRITZ FOLEY

E. SCOTT MAYFIELD

F. KATELYNN BOLAND The Transformation of Microsoft

In early 2015, Microsoft’s CFO Amy Hood and the rest of the senior leadership team were preparing for the Financial Analyst Meeting that was set to take place at the end of April. After more than a decade of price stagnation, shares of Microsoft had recently appreciated in value, but analysts remained mixed in their outlook. Hood wanted to use the upcoming event to articulate how and why Microsoft would be relevant in the future.

The firm had reached a pivotal point in its evolution. Windows 10, due to be released in a few months, would be the first version to continuously update. Historically, new versions gained adoption when users bought new PCs, but the PC market was declining, and there were concerns about whether users would upgrade. Some advocated for giving Windows 10 away to certain customers. Sales of Office were also shifting away from versions sold under a perpetual license toward Office 365, a subscription service. Microsoft's cloud computing platform Azure had grown to include a broad set of offerings, and many users were adopting it to implement workloads and services that could complement, or perhaps replace, their on-premise investments. Across all these offerings, Microsoft was poised to capture opportunities to serve larger total addressable markets (TAMs). However, adapting business practices gave rise to business model risk, and, furthermore, most adaptions that had been initiated were associated with lower margins than the practices that they replaced.

There were reasons to be skeptical about Microsoft’s abilities to prevail as it transformed. Although it had been a leading technology firm for decades, it failed to capitalize on several recent trends. In search, Bing struggled to gain market share against Google; in messaging, Microsoft offerings held only a small share; and in mobile, attempts to enter the phone market had floundered. Several recent shifts in strategic positioning also raised questions about how credible Microsoft was in delineating a vision for the future. Over the last three years, the strategic focus had been described as being “Windows first,” then “devices and services,” and then “mobile-first, cloud-first.”

Hood and Chris Suh, who ran investor relations, faced immediate questions about what they should tell investors. How much detail should they give about where the firm was headed and how it would get there? Should Hood state specific financial goals for different parts of the business? These questions related to more fundamental decisions. How aggressively should Microsoft try to transform the ways

Professor C. Fritz Foley, Senior Lecturer E. Scott Mayfield, and Research Associate F. Katelynn Boland prepared this case. It was reviewed and approved before publication by a company designate. Funding for the development of this case was provided by Harvard Business School and not by the company. Certain numbers are hypothetical. HBS cases are developed solely as the basis for class discussion. Cases are not intended to serve as endorsements, sources of primary data, or illustrations of effective or ineffective management. Professor C. Fritz Foley is a Microsoft shareholder.

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it made money? Given that many of the changes to the business model were associated with lower margin, did it make sense to sacrifice margin for growth?

Company Background History

Microsoft was founded in 1975 by Bill Gates and Paul Allen with the intention of developing software for the nascent PC industry.1 Steve Ballmer joined the firm in 1980, becoming Microsoft’s 30th employee.2 In that same year, Microsoft developed the MS-DOS operating system and entered into an agreement to receive a royalty for installing it on all IBM PCs.3 Three years later, Word, the first part of the Office suite of productivity applications to be released, was first sold, and Windows was launched shortly thereafter in 1985.4 Within a few years, Word and Excel displaced numerous competitors, and Windows’ usage share on PCs exceeded 90% beginning in 1993.56 Throughout the 1990s and early 2000s, Microsoft developed other lines of business related to servers, web offerings, business operating systems, multimedia products, and gaming. Exhibits 1, 2, and 3 provide recent income statement, balance sheet, and cash flow data for Microsoft, respectively.

Microsoft originally distributed many products to customers through computer and software retailers like Egghead. High levels of demand pushed a variety of enterprises to establish relationships with Microsoft under which Microsoft provided products on a contractual basis. Before the spread of the internet, Microsoft product updates were released every few years. As a consequence, products needed to be highly reliable, and developers focused on building solutions which had a high mean time to failure.

Microsoft in 2012

Business Segments By the end of 2012, Microsoft was divided into five distinct segments: the Windows and Windows Live Division, Server and Tools, the Online Services Division, the Microsoft Business Division, and the Entertainment and Devices Division.7 At this time, Microsoft Business Division was the largest division, accounting for roughly a third of revenues, and the Windows and Windows Live Division and Server and tools were each responsible for about a quarter of total revenues. The revenues of the Entertainment and Devices Division were about 13% of the total and the remaining roughly 4% of revenues was generated by the Online Services Division.

The Windows and Windows Live Division was responsible for developing the PC operating system, Windows 7 at the time, and any related software and online services or hardware products. This segment played a crucial role in defining Microsoft’s market presence because a software platform was needed on every computer in order for application programs to run properly. Windows performed basic jobs, such as input and output recognition, as well as intricate tasks, such as security and program coordination. Approximately 75% of the revenue from this division came from OEM sales, as many PCs came with Windows pre-installed. Windows Live was a set of software products and web-based services like Windows Live Messenger and Windows Mail.

Microsoft had a substantial presence in server and network offerings. Server offerings could be run at a customer's site or in the cloud. The Server and Tools Division developed and marketed server software, such as the database management system Microsoft SQL Server, as well as software developer tools, services, and solutions, including the cloud computing service Windows Azure and the product support and consulting service Enterprise Services.

Microsoft developed information and content to simplify online tasks, to facilitate online decision making, and to enhance the effectiveness of advertisers. Tasks related to these activities were performed by the Online Services Division, primarily through the web search engine Bing, news and information service MSN, and search advertising network adCenter. Advertisements accounted for nearly all of the Online Services annual revenue. In December 2009, Microsoft and Yahoo! entered into an agreement under which Microsoft provided the exclusive algorithmic and paid search platform for Yahoo! websites worldwide. The agreement gave Microsoft and Yahoo! a combined market share of about 30% of the US search advertising market.8

The Microsoft Business Division’s primary offerings included the Microsoft Office system and Microsoft Dynamics. The Microsoft Office system, which included Office, SharePoint, Exchange, Lync, and Office 365, generated over 90% of the division’s revenue. Microsoft Dynamics provided solutions to businesses through software applications that enabled resource planning and customer relationship management. Approximately 80% of the Microsoft Business Division revenue was generated from sales to businesses, and the remaining revenue was derived from sales to consumers.

The Entertainment and Devices Division had the objective of entertaining and connecting people. Its offerings included Xbox gaming, Windows Phone, and Skype, which was acquired in 2011. This segment was invested in establishing platforms that created connectivity between users.

Each segment was structured with its own management team, including its own CFO, controller, and marketing team. Each separately maintained its own profit and loss (P&L) statement and reported to its own division head. Exhibit 4 provides revenue and operating income for each segment from 2010 through 2012.

Even though Microsoft had multiple lines of business, Windows remained at its core. Some referred to Microsoft as having a “Windows first” outlook and claimed that products that threatened Windows would not be released or would have certain features removed from them.9

Performance Metrics Internally, the firm’s performance was closely measured relative to a detailed set of metrics. The notion of “revenue per socket” was developed which was a way of measuring revenue per user in different parts of the business, and this became a key performance metric.

Chief Operating Officer Kevin Turner also optimized activities. Turner had joined Microsoft in 2005 as Chief Operating Officer (COO) from Wal-Mart, where he had driven efficiencies as CIO of the whole company and CEO of Sam’s Club.10 Turner was tasked with instilling discipline into operations and sales.11 Each January Turner ran a six week mid-year review process in which business heads reported out on their progress. These reviews required considerable preparation, and managers who were not performing up to expectation needed to undertake what was referred to as a “correction of errors.” Turner articulated the logic that motivated the pursuit of operations excellence in the 2011 Financial Analyst Meeting: “Operational excellence is about execution. And that's clearly the key focus that we've been on is, as a company, we've embraced the fact that execution is strategic…And when you think about where we've come from, from an execution standpoint, one of the things that we weren't very good at previously was this idea of managing cost and how good are we going to do from a cost- management perspective.”12

Company Culture Microsoft’s culture of the early 2000s had some critics. They asserted that some individuals exhibited a know-it-all mentality and that hierarchy and bureaucracy predominated. The demands of developing products that had few, if any, flaws had, in the minds of some, led to an intolerance of failure. Board member John Thompson commented on the challenges these behaviors

presented to collaborative efforts: “The culture of this place was: If you’re the smartest person in the room, you can also be the rudest and crudest person in the room. Intellect mattered, and therefore the interpersonal actions were not what they needed to be.”13 CEO Satya Nadella echoed that sentiment, “Our culture has been rigid. Each employee had to prove to everyone that he or she knew it all and was the smartest person in the room. Accountability – delivering on time and hitting numbers – trumped everything. Meetings were formal. Everything had to be planned in perfect detail before the meeting. And it was hard to do a skip-level meeting. If a senior leader wanted to tap the energy and creativity of someone lower down in the organization, she or he needed to invite that person’s boss, and so on. Hierarchy and pecking order had taken control, and spontaneity and creativity suffered as a result.”14

2013 Reorganization

In 2013, core features of the hardware, software, and computing services industries were changing. The sale of prepackaged operating systems and software on PCs was on the decline. Between 2011 and 2013, worldwide PC shipments fell from more than 350 million units to about 320 million units, and volumes were expected to remain low.15 The ways in which consumers and businesses interacted with technology were changing as adoption of smartphones and tablets increased.

In response to these trends, Microsoft announced a significant reorganization so that it could pursue the strategy of being a devices and services company. Explaining the logic of this reorganization, Ballmer wrote, “As technology moves from people’s desks to everywhere in their lives, it should become simpler, not more complex. And our products and services should operate as one experience across every device…. Going forward, our strategy will focus on creating a family of devices and services for individuals and businesses that empower people around the globe at home, at work and on the go, for the activities they value most.”16

After the reorganization, operations were split into two kinds of segments, Devices and Consumer segments and Commercial segments. Devices and Consumer segments focused on providing products and services that enhanced personal productivity, supported online decision making, entertained and connected people, and enabled advertisers to connect with people more effectively.17 It included the D&C Licensing segment, which handled OEM and non-volume licensing of several Microsoft offerings, the D&C Hardware segment, which developed computing and gaming hardware including Surface, and the D&C other segment that provided a mix of products and services including Office 365 Home, Xbox Live Transactions and the offerings of the Windows store and Windows Phone store.

The Commercial segments offerings aimed to increase the productivity and efficiency in commercial settings. The Commercial Licensing segment offerings included server products, such as Windows SQL Server, volume licensing of the Windows operating system and Microsoft Office for business, Skype, and most of Microsoft Dynamics. The Commercial Other segment provided enterprise services like consulting services and commercial cloud services including Office 365 Commercial and Microsoft Azure. Exhibit 4 provides revenue and operating income for each segment in 2013 and 2014.

In September 2013, the strategy of being a devices and services business got a boost when Microsoft announced its intention to acquire Nokia’s devices and services businesses for roughly $7.2 billion in cash.18 Nokia had partnered with Microsoft in 2011, and it supplied more than 90% of the Windows phone market. There were concerns that Nokia would switch to making Android phones when the partnership agreement ended in 2014.

As this restructuring took place, Microsoft share price increased. After hovering in the twenties for more than a decade, its 2013 closing price was $37.41. In 2014, according to one classification of investors, roughly 34% of shares were held by index investors, 28% by value investors, and 22% by growth investors.19 One notable shareholder was activist investor group ValueAct Capital. In April 2013, ValueAct took a $2 billion dollar stake in Microsoft, roughly amounting to 0.8% of Microsoft's shares.20 Speaking at an investor conference, ValueAct CEO Jeffery Ubben urged Microsoft to make its products more widely available outside of Windows. It was also speculated that ValueAct sought higher dividends and share buybacks for shareholders.21 However, Microsoft had already been returning cash to shareholders through dividends and repurchases on a consistent basis. During the 2013 fiscal year, more than $7 billion was returned in the form of dividends and more than $4 billion in the form of repurchases.22

New Senior Leadership

Along with the reorganization of the company and focus on a new strategy, there were also changes in senior leadership. On May 8, 2013 Amy Hood was named Microsoft’s new Chief Financial Officer. A 1999 graduate of Harvard Business School, Hood had been with Microsoft since 2002. Initially Hood joined the Investor Relations group before serving as chief of staff in Server and Tools. She then worked in Microsoft's Business Division, first running the strategy and business development team and eventually becoming its CFO in January 2010.23 Hood had been heavily involved in Microsoft’s acquisitions of Skype and Yammer.24

Later in 2013, surprising many company insiders and observers, Steve Ballmer announced his intention to step down as CEO once a new CEO was secured as his replacement. In an internal email he stated, “There is never a perfect time for this type of transition, but now is the right time…We need a CEO who will be here longer term for this new direction.”25 There was a great deal of speculation on who would occupy the role next. Among the list of possibilities was Ford Motor Company’s CEO Alan Mulally, but the job went to insider Satya Nadella in early 2014. 26 Nadella had been with Microsoft since 1992. He had held a variety of leadership roles, including the Head of Dynamics Business Software Development, Senior Vice President of Research and Development for the Online Services Division, Executive Vice President of Cloud and Enterprise Engineering Group, and President of Server and Tools.27 Nadella had worked with Hood in Server and Tools.

Microsoft in 2015

With new leadership in place, Microsoft’s strategic direction and management practices were at a critical point in their development. Soon after becoming CEO, Nadella began to articulate a “mobile- first, cloud-first” strategy. This entailed a focus on enabling users to be productive across a broad set of devices seamlessly. The vision was that Microsoft mobile apps that were available on all popular platforms would drive users to access the firm’s cloud-based offering. The strategy was a significant departure from a “Windows first” strategy.

It was also distinct from the pursuit of being a “devices and services” provider. A very concrete indicator of this came in the form of an announcement regarding the Microsoft phone unit. The Nokia acquisition that had occurred just two years earlier had not yielded the results that were hoped for, and Microsoft’s phone business had failed to meet its sales volume and revenue goals. By some calculations, it lost money on each device it sold.28 Only 2.7% of smartphones sold in the first three months of 2015 were powered by Windows.29 Given this limited progress, the strength of the competition in this space, and a desire to streamline the breadth of firm activities, Nadella announced

that the unit would be shut down: “We are moving from a strategy to grow a standalone phone business to a strategy to grow and create a vibrant Windows ecosystem that includes our first-party device family.” Microsoft took an impairment charge of $7.6 billion and anticipated that restructuring costs would be in the $650-$750 million range.30 The brief, costly attempt to scale its phone business left some wondering if the firm had lost its way. Writing in Forbes, Adam Hartung concluded that “Microsoft lacks a viable long-term strategy.”31

The senior leadership team faced several choices about what to emphasize as the firm transformed. One choice related to the pricing of Windows 10. Historically, Windows was sold primarily through hardware OEMs and customers upgraded their software when they purchased a new PC or a new version of Windows. It took years for the majority of the installed base to run the latest version of Windows, and therefore most customers were not able to take advantage of the latest features in Microsoft’s software. Windows 10 was built as a service that delivered ongoing feature innovations and security updates, which were downloaded and installed automatically at no additional cost to the customer. In order to move the installed base to this services model, some argued that Windows 10 upgrade licenses should be given away at no cost for a period of time for devices with genuine editions of Windows 7 or 8.

Another choice concerned whether and how actively the firm should shift from selling Office on a perpetual basis to selling it on a subscription basis in the consumer market. Office 365, a subscription service offering applications that were always up to date, was an alternative to versions of Office that could be bought under a perpetual license. In the consumer market, customers had typically only bought new versions of Office every 5-7 years, and many were using versions that seemed to lack functionality relative to competitor applications like Google Docs, which allowed users to create and edit files online. Annual subscription fees were often a fraction of the cost of perpetual licenses. For example, a basic set of Office applications could be purchased for about $180 under a perpetual license, while the Office 365 version of those same applications would cost about $100 a year. A shift to annuity- like income had the potential to increase sales, but it posed business model risk and would likely be associated with lower margins. Microsoft would need to move its install base to a new model after decades of monetizing through the sale of new devices. In addition, cloud hosted email, storage, and other services, as well as the provision of updates, increased the costs relative to the costs of software sold under a perpetual license. Gross margins would likely be lower, at least for some period of time. These considerations were less salient in the commercial market because Office sales already took place on a multi-year contractual basis.

The activities that had been characterized as the Server and Tools businesses before the 2013 reorganization were also evolving. Changes were in large part due to the growth of cloud based services. By 2015, Azure included more than forty integrated offerings across compute, storage, data, networking, and application services.32 By serving users through the cloud, Microsoft could capture the scale benefits of data and computing centers and enhance the utilization of computing, storage, and network resources. The economical and scalable nature of the offerings made them particularly attractive to small and medium size organizations, which had historically found on-premise solutions to be prohibitively expensive. However, Azure earned lower margins than the traditional on-premise server and tool business. In addition, Amazon Web Services (AWS) had developed a dominant position in cloud services, and Microsoft would need to invest billions in data centers to compete.

In short, in several areas Microsoft faced opportunities to grow, but many of these opportunities were accompanied by lower margins. These lower margins were likely to be persistent. Even though operating expenditures were tightly controlled, investment in such expenses would be required to drive growth, and many operating expenditures would scale with sales. Additional capital

expenditures were required as well. A key question facing the senior leadership team was the question of how aggressively they should pursue growth if higher growth implied reduced margins. Innovation had been core to Microsoft’s identity, but Nadella also recognized underlying market dynamics and the pressure from investors to focus on short-term earnings and “cash-cow” the business.33 Managing the firm through its transformation would require changes in performance metrics and in culture.

Performance Metrics

Soon after taking on the role of CFO, Hood concluded that the firm needed to do more to articulate its financial prospects. She and others were frustrated that the stock price had been fairly flat for more than a decade even though the firm consistently produced good earnings. “The PE went down to like 8 or 9 times. We had consistent performance, but generated no confidence. People did not believe we were relevant.”34

At a 2015 retreat for senior Microsoft executives, Hood gave a speech in which she articulated the need for what she labelled performance and power metrics. Performance metrics referred to measures that indicated if Microsoft served customers well with products and services that had been released. These metrics provided a sense of how satisfied customers were with what was in the market place, and they included indicators that were critical for business continuity. Power metrics were, for the most part, a new focus, and they helped define where the firm was going and targeted milestones along the way. They were leading indicators that aimed to capture the extent to which the firm was developing sustainable differentiation. For example, the rate of server products and cloud services revenue growth could be considered to be a power metric because it highlighted the impact adoption of cloud services had on the company’s traditional server software sales. Many power metrics used within Microsoft related to engagement and consumption. For example, because Office 365 was cloud based, it was possible to measure and analyze if customers were adopting and using functionality that might be a small part of the firm’s current business but were expected to grow.

Hood emphasized the need to measure both performance and power and the need to excel in both areas. She pointed out that highly performing current offerings paved the way for sustained advantage in the future and helped ensure the firm had the resources, as well as the internal and external support, to pursue innovations. Designing effective power metrics required considerable humility given the difficulty of accurately charting where the firm was headed. Therefore, Hood and her team adopted a relatively flexible approach when implementing these metrics. When a part of the firm appeared to face challenges making progress towards a goal, it became an opportunity to explore if the TAM was as large as expected, if there was a market selection problem, or if there was an execution problem. Metrics that proved to be ineffective were abandoned.

Culture Transformation

While Nadella was thinking through strategic choices, he also had a deep appreciation for the view expressed by Peter Drucker that “culture eats strategy for breakfast.”35 Soon after becoming CEO, he asked Kathleen Hogan, who was leading Microsoft’s global consulting and support business, to become the firm’s Chief People Officer and help drive cultural change. After considerable thinking and discussion among the senior leadership team, Nadella articulated a vision for the firm’s culture in a memo to employees. He wrote, “We fundamentally believe that we need a culture founded in a growth mindset. It starts with a belief that everyone can grow and develop; that potential is nurtured, not predetermined; and that anyone can change their mindset. Leadership is about bringing out the best in people, where everyone is bringing their A game and finding deep meaning in their work. We need to be always learning and insatiably curious. We need to be willing to lean in to uncertainty, take risks

and move quickly when we make mistakes, recognizing failure happens along the way to mastery. And we need to be open to the ideas of others, where the success of others does not diminish our own.”36

Nadella also highlighted three areas where the growth mindset should be applied. The first of these was in the firm’s desire to be obsessed with customers. A growth mindset could enhance the firm's commitment to learn about and address customer needs. Such a mindset also facilitated the objective of being a diverse and inclusive organization. An open-minded approach based on the belief in the capacity for people to develop would help tap into the collective power of a diverse workforce. Finally, Nadella urged employees to apply a growth mindset to the goal of operating as “One Microsoft.” Collaborating across boundaries within the firm necessitated changes in behavior.

Pushing the cultural change required lots of communication, socialization and considerable buy in from all levels of management. At a 2015 retreat, senior leaders became part of what was called the culture cabinet.37 Ideas were rolled out through the firm’s 16,000 managers. In addition, Nadella took the opportunity to emphasize the importance of culture in unexpected settings. The closing of the annual sales summit was typically a boisterous event, but in 2015 Nadella delivered solemn closing remarks about the importance of culture in front of a banner that simply read “Culture, Growth Mindset.”

These new cultural attitudes encouraged behavioral changes throughout the firm, even within the finance function. For example, one initiative that was introduced would move the firm from an annual budgeting process to a rolling set of forecasts. Such forecasts embodied the view that things do not typically go according to plan and there is value in taking a first step, adjusting, and then continuing to head in the right direction.

Preparing for the Financial Analyst Meeting

As Hood and the rest of the senior leadership team prepared for the upcoming financial analyst meeting, there were several outstanding questions about how to communicate the firm’s performance and prospects. Hood wanted to show investors how Microsoft would be relevant in the future by explaining where the firm was headed. The growth in commercial cloud, which was comprised of Office 365, Azure, and Dynamics 365, could be a key part of this story, but would it be sensible to publicly set a commercial cloud revenue target? One goal that had been discussed internally was the goal of achieving a $20 billion annualized run rate in fiscal year 2018; this was a stretch from the current run rate of roughly $6 billion.38 In addition, there were questions of how much detail the senior leadership team should share about the hypothesized economics of the changes that were underway. For example, internal analysis of several offerings generated estimates of their lifetime value, or the gross profit earned over the life of a typical customer. Should Hood share internal views about how the lifetime value of a representative Office customer would change if the customer became an Office 365 customer? There was no guarantee that estimates would prove to be correct.

These questions were interwoven with fundamental strategic choices. Would Microsoft investors be better off if managers “cash-cowed” the business and focused on the opportunity to generate cash- flow from existing products and the current install base? How aggressively should Microsoft pursue the growth opportunities it faced? Was growth desirable if it came with lower margins?

Exhibit 1 Microsoft’s Income Statement (in millions, except per share amounts)

Year Ended June 30, 2014 2013 2012 2011 Revenue $86,833 $77,849 $73,723 $69,943 Cost of revenue 26,934 20,249 17,530 15,577 Gross margin 59,899 57,600 56,193 54,366 Research and development 11,381 10,411 9,811 9,043 Sales and marketing 15,811 15,276 13,857 13,940 General and administrative 4,821 5,149 4,569 4,222 Goodwill impairment - - 6,193 - Integration and restructuring 127 - - - Operating income 27,759 26,764 21,763 27,161 Other income (expense), net 61 288 504 910 Income before income taxes 27,820 27,052 22,267 28,071 Provision for income taxes 5,746 5,189 5,289 4,921 Net income 22,074 21,863 16,978 23,150 Earnings per share: Basic $2.66 $2.61 $2.02 $2.73 Diluted $2.63 $2.58 $2.00 $2.69 Weighted-average common shares outstanding: Basic 8,299 8,375 8,396 8,490 Diluted 8,399 8,470 8,506 8,593 Cash dividends declared per common share $1.12 $0.92 $0.80 $0.64

Source: Microsoft SEC filings FY2014 10K for 2014-2012; FY2013 10K for 2011.

Exhibit 2 Microsoft’s Balance Sheet (in millions)

Year Ended June 30, 2014 2013 2012 2011

ASSETS Current Assets: Cash and cash equivalents $8,669 $3,804 $6,938 $9,610 Short-term investments 77,040 73,218 56,102 43,162 Total cash, cash equivalents, and short-term investments 85,709 77,022 63,040 52,772

Accounts receivable, net of allowance for doubtful accounts 19,544 17,486 15,780 14,987 Inventories 2,660 1,938 1,137 1,372 Deferred income taxes 1,941 1,632 2,035 2,467 Other 4,392 3,388 3,092 3,320 Total current assets 114,246 101,466 85,084 74,918

Property and equipment, net of accumulated depreciation 13,011 9,991 8,269 8,162 Equity and other investments 14,597 10,844 9,776 10,865 Goodwill 20,127 14,655 13,452 12,581 Intangible assets, net 6,981 3,083 3,170 744 Other long-term assets 3,422 2,392 1,520 1,434 Total Assets 172,384 142,431 121,271 108,704

LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $7,432 $4,828 $4,175 $4,197 Short-term debt 2,000 - - - Current portion of long-term debt - 2,999 1,231 - Accrued compensation 4,797 4,117 3,875 3,575 Income taxes 782 592 789 580 Short-term unearned revenue 23,150 20,639 18,653 15,722 Securities lending payable 558 645 814 1,208 Other 6,906 3,597 3,151 3,492 Total current liabilities 45,625 37,417 32,688 28,774

Long-term debt 20,645 12,601 10,713 11,921 Long-term unearned revenue 2,008 1,760 1,406 1,398 Deferred income taxes 2,728 1,709 1,893 1,456 Other long-term liabilities 11,594 10,000 8,208 8,072 Total Liabilities 82,600 63,487 54,908 51,621

Commitments and contingencies Stockholders' equity: Common stock and paid-in capital 68,366 67,306 65,797 63,415 Retained earnings 17,710 9,895 (856) - Accumulated other comprehensive income 3,708 1,743 1,422 (6,332) Total stockholders' equity 89,784 78,944 66,363 57,083 Total Liabilities and Stockholders' Equity 172,384 142,431 121,271 108,704

Source: Microsoft SEC filings, FY2014 10K for 2014-2013; FY2013 10K for 2012; FY2012 10K for 2011.

Exhibit 3 Microsoft’s Cash Flows Statements (in millions)

Year Ended June 30, 2014 2013 2012 2011

Operations Net income $22,074 $21,863 $16,978 $23,150 Adjustments to reconcile net income to net cash from operations: Goodwill and asset impairments - - 6,193 - Depreciation, amortization, and other 5,212 3,755 2,967 2,766 Stock-based compensation expense 2,446 2,406 2,244 2,166 Net recognized losses (gains) on investments and derivatives (109) 80 (200) (362) Excess tax benefits from stock-based compensation (271) (209) (93) (17) Deferred income taxes (331) (19) 954 2 Deferral of unearned revenue 44,325 44,253 36,104 31,227 Recognition of unearned revenue (41,739) (41,921) (33,347) (28,935) Changes in operating assets and liabilities: Accounts receivable (1,120) (1,807) (1,156) (1,451) Inventories (161) (802) 184 (561) Other current assets (29) (129) 493 (1,259) Other long-term assets (628) (478) (248) 62 Accounts payable 473 537 (31) 58 Other current liabilities 1,075 146 410 (1,146) Other long-term liabilities 1,014 1,158 174 1,294 Net cash from operations 32,231 28,833 31,626 26,994

Financing Proceeds from issuance of short-term debt, maturities of 90 days or less, net 500 - - (186) Proceeds from issuance of debt 10,350 4,883 - 6,960 Repayments of debt (3,888) (1,346) - (814) Common stock issued 607 931 1,913 2,422 Common stock repurchased (7,316) (5,360) (5,029) (11,555) Common stock cash dividends paid (8,879) (7,455) (6,385) (5,180) Excess tax benefits from stock-based compensation 271 209 93 17 Other (39) (10) - (40) Net cash used in financing (8,394) (8,148) (9,408) (8,376)

Investing Additions to property and equipment (5,485) (4,257) (2,305) (2,355) Acquisition of companies, net of cash acquired, and purchases of intangible and other assets (5,937) (1,584) (10,112) (71) Purchases of investments (72,690) (75,396) (57,250) (35,993) Maturities of investments 5,272 5,130 15,575 6,897 Sales of investments 60,094 52,464 29,700 15,880 Securities lending payable (87) (168) (394) 1,026 Net cash used in investing (18,833) (23,811) (24,786) (14,616)

Exhibit 3 (continued)

Year Ended June 30, 2014 2013 2012 2011

Effect of foreign exchange rates on cash and cash equivalents (139) (8) (104) 103 Net change in cash and cash equivalents 4,865 (3,134) (2,672) 4,105 Cash and cash equivalents, beginning of period 3,804 6,938 9,610 5,505 Cash and cash equivalents, end of period 8,669 3,804 6,938 9,610

Source: Microsoft SEC filings, FY2014 10K for 2014-2012; FY2013 10K for 2011.

Exhibit 4 Microsoft Segment Data (in millions)

Segments through 2012 2014 2013 2012 2011

Windows & Windows Live Revenue $18,373 $19,033 Division Operating income 11,460 12,211 Revenue 18,686 16,680 Server and Tools Operating income 7,431 6,290 Revenue 2,867 2,607 Online Services Division Operating income (8,121) (2,657) Revenue 23,991 22,514 Microsoft Business Division Operating income 15,719 14,657

Entertainment and Devices Revenue 9,593 8,915 Division Operating income 364 1,257

Segments after 2012 2014 2013 2012 2011 Licensing $18,803 $19,021 Hardware 11,613 6,461 Revenue Devices and Consumer Other 7,258 6,618 Total 37,674 32,100 Operating income 8,714 9,421 Licensing 42,027 39,686 Revenue Other 7,547 5,660 Commercial Total 49,574 45,346 Operating income 23,467 21,132 Revenue (415) 403 Corporate and Other Operating income (4,422) (3,789)

Source: Microsoft SEC filings, FY2014 10K for 2014-2013; FY2012 10K for 2012-2011.

Endnotes

1 Jonathon Byrnes. (2010, September 21). How Microsoft Became MICROSOFT. In Business Insider online. Retrieved from http://www.businessinsider.com/how-did-microsoft-become-microsoft-2010-9.

2 Mazarakis, Anne and Alyson Shontell. (2017, July 26). Clippers Owner and former Microsoft CEO Steve Ballmer Reveals How He Became the World’s Happiest Retired Billionaire. In Business Insider online. Retrieved from http://www.businessinsider.com/steve-ballmer-career-advice-from-clippers-owner-and-ex-microsoft-ceo-2017-7.

3 Miller, Michael J. (2011, August 10). The Rise of DOS: How Microsoft Got the IBM PC OS Contract. In PC Magazine online. Retrieved from http://forwardthinking.pcmag.com/software/286148-the-rise-of-dos-how-microsoft-got-the-ibm-pc-os- contract.

4 Facts About Microsoft. (n.d.). Retrieved from https://news.microsoft.com/facts-about-microsoft.

5 Vaughan-Nichols, Steven J. (2012, December 12). Windows Has Fallen Behind Apple iOS and Google Android. In ZDNet online. Retrieved from http://www.zdnet.com/article/windows-has-fallen-behind-apple-ios-and-google-android.

6 Worstall, Tim. (2012, December 13). Microsoft’s Market Share Drops From 97% to 20% In Just Over A Decade. In Forbes online. Retrieved from https://www.forbes.com/sites/timworstall/2012/12/13/microsofts-market-share-drops-from-97-to-20-in- just-over-a-decade/#5b5e02b251cf.

7 Microsoft. (2012). 10-K Annual Report 2012. Retrieved from SEC EDGAR database.

8 Microsoft and Yahoo Seal Web Deal. (2009, July 29). In BBC News online. Retrieved from http://news.bbc.co.uk/1/hi/business/8174763.stm.

9 Head in the Cloud. (2017, March 16). In The Economist online. Retrieved from https://www.economist.com/news/business/21718916-worlds-biggest-software-firm-has-transformed-its-culture-better- getting-cloud.

10 Levinson, Meridith. (2002, October 1). CIO 20/20 Honorees – Leadership Profile: Kevin Turner of Sam’s Club. In CIO online. Retrieved from https://www.cio.com/article/2440519/leadership-management/cio-20-20-honorees--leadership-profile-- kevin-turner-of-sam-s-club.html.

11 Bass, Dina. (2016, July 7). Microsoft’s Nadella Reshapes Top Management as Turner Leaves. In Bloomberg online. Retrieved from https://www.bloomberg.com/news/articles/2016-07-07/microsoft-s-nadella-reshapes-management-team-as-turner- leaves.

12 Turner, Kevin. (2011, September 14). 2011 Financial Analyst Meeting Transcript. Retrieved from www.microsoft.com/investor/downloads/events/09142011_FAM_Turner.docx.

13 Gerut, Amanda. (2017, July 10). How Microsoft Reformed Its Toxic Culture. In Agenda online. Retrieved from http://www.agendaweek.com/pc/1676093/196903.

14 Nadella, Satya, Tracie Nichols, and Greg Shaw. (2017). Hit Refresh. New York, NY: HarperCollins Publishers, p. 101.

15 Gorham, Melissa, Jennifer Swanson Lowe, and Keith Weiss. (2013, August 13). Under the Hood: Microsoft Windows Division. Morgan Stanley Research. Retrieved from Thomson Reuters database.

16 Ludwig, Sean. (2013, July 11). Massive Microsoft reorg unifies the company: ‘One Strategy, One Microsoft’. In Venture Beat online. Retrieved from https://venturebeat.com/2013/07/11/microsoft-reorg.

17 Microsoft. (2013). 10-K Annual Report 2013. Retrieved from SEC EDGAR database.

18 Kovach, Steve. (2014, April 25). Microsoft Closes Its $7.2 Billion Purchase of Nokia. In Business Insider online. Retrieved from http://www.businessinsider.com/microsoft-closes-nokia-acquisition-2014-4.

19 Chris Suh, interview, September 20, 2017.

20 Reuters Staff. (2013, April 22). ValueAct Takes $2 Billion Microsoft Stake. In Reuters online. Retrieved from http://uk.reuters.com/article/us-microsoft-valueact/valueact-takes-2-billion-microsoft-stake-idUSBRE93L0KM20130422.

21 Reuters Staff. (2013, August 30). Microsoft Offers ValueAct President Seat on Board. In Reuters online. Retrieved from https://www.reuters.com/article/us-microsoft-valueact/microsoft-offers-valueact-president-seat-on-board- idUSBRE97T0X520130830.

22 Microsoft. (2013). 10-K Annual Report 2013. Retrieved from SEC EDGAR database.

23 McCarthy, Bede. (2013, May 9). Amy Hood to Take on Chief Financial Officer Role at Microsoft. In Financial Times online. Retrieved from https://www.ft.com/content/3b6f1388-b890-11e2-a6ae-00144feabdc0?mhq5j=e6.

24 Microsoft News Center. (2013, May 8). Microsoft Names Amy Hood as New Microsoft Chief Financial Officer. In Microsoft blogs online. Retrieved from https://blogs.microsoft.com/blog/2013/05/08/microsoft-names-amy-hood-as-new-microsoft- chief-financial-officer.

25 Network World Staff. (2013, August 23). Microsoft CEO Steve Ballmer’s Retirement Announcement Letter. In Network World online. Retrieved from http://www.networkworld.com/article/2169306/data-center/microsoft-ceo-steve-ballmer-s- retirement-announcement-letter.html.

26 Reed, Tom. (2012, April 3). 6 Leadership Tips from Ford CEO Alan Mulally. In The Street online. Retrieved from https://www.thestreet.com/story/11480044/3/6-leadership-tips-from-ford-ceo-alan-mulally.html.

27 Satya Nadella. (n.d.). In Bloomberg online. Retrieved from https://www.bloomberg.com/profiles/people/3224315-satya- nadella.

28 Day, Matt and Janet I. Tu. (2015, June 15). Nadella Shakes Up Microsoft At Top Level. In The Seattle Times online. Retrieved from https://www.seattletimes.com/business/microsoft/nadella-shakes-up-microsoft-at-top-level.

29 Microsoft News Center. (2015, July 2015). Satya Nadella Email to Employees on Sharpening Business Focus. In Microsoft news online. Retrieved from https://news.microsoft.com/2015/07/08/satya-nadella-email-to-employees-on-sharpening- business-focus.

30 Darrow, Barb. (2015, July 8). Can We Agree That The Nokia Buy Was A Total Disaster for Microsoft? In Fortune online. Retrieved from http://fortune.com/2015/07/08/was-microsoft-nokia-deal-a-disaster.

31 Hartung, Adam. (2015, July 8). A $7.8B Write-Off Is Never a Good Sign, Microsoft. In Forbes online. Retrieved from https://www.forbes.com/sites/adamhartung/2015/07/08/a-7-6b-write-off-is-never-a-good-sign-microsoft/#579008182eff.

32 Azure. (n.d.) In Microsoft Azure online. Retrieved from https://azure.microsoft.com/en-us.

33 Nadella, Satya, Tracie Nichols, and Greg Shaw. (2017). Hit Refresh. New York, NY: HarperCollins Publishers, p. 65.

34 Amy Hood, interview, June 29, 2017.

35 Nadella, Satya, Tracie Nichols, and Greg Shaw. (2017). Hit Refresh. New York, NY: HarperCollins Publishers, p. 90.

36 Kim, Eugene. (2015, June 25). Microsoft Has A Strange New Mission Statement. In Business Insider online. Retrieved from http://www.businessinsider.com/microsoft-ceo-satya-nadella-new-company-mission-internal-email-2015-6.

37 Samdahl, Erik. (2017, February 15). Kathleen Hogan: How Microsoft Is Transforming Its Culture. In i4CP online. Retrieved from https://www.i4cp.com/interviews/kathleen-hogan-how-microsoft-is-transforming-its-culture.

38 Dignan, Larry. (2015, April 23). Microsoft’s Q3 Strong, Commercial Cloud on $6.3 Billion Annual Run Rate. In ZDNet online. Retrieved from http://www.zdnet.com/article/microsofts-q3-strong-commercial-cloud-on-6-3-billion-annual-run-rate.