Welcome to Microsoft's Fiscal Year 2012 Second Quarter Earnings Conference Call. [Operator Instructions] Today's call is being recorded. If anyone has any objections, you may disconnect at this time. I would now like to turn the call over to Bill Koefoed, General Manager, Investor Relations. Bill, you may begin.

Thank you, operator, and thank you, everyone, for joining us this afternoon. As usual, with me today are Peter Klein, Chief Financial Officer; Frank Brod, Chief Accounting Officer; and John Seethoff, Deputy General Counsel. On our website is our financial summary slide deck, which is intended to follow our prepared remarks and provides the reconciliation of differences between GAAP and non-GAAP financial measures. This information is available at microsoft.com/investor. As a reminder, we will post today's prepared remarks to our website immediately following the call until the complete transcript is available. Today's call is being webcast live and recorded. If you ask a question, it will be included in our live transmission, in the transcript and any future use of the recording. You can replay the call and view the transcript at the Microsoft Investor Relations website until January 19, 2013. During this call, we will be making forward-looking statements. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could materially differ because of factors discussed in today's earnings press release, in the comments made during this conference call and in the Risk Factors section of our Form 10-K, Form 10-Qs and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statement. Okay, and with that, I'll turn the call over to Peter.

Thanks, Bill, and thanks everyone for joining us. I'm pleased with our performance this quarter. Despite a challenging PC market, we delivered solid financial results. We saw a strong demand for our business products and services and had a record holiday season, driven by the unique entertainment experience we have built with Xbox 360. This quarter, the strength of our product portfolio enabled us to grow revenue 5% to $20.9 billion. Combined with our ongoing operating expense discipline, even as we prepare for a big launch year, we delivered record earnings per share of $0.78. Similar to prior periods, we saw a broad-based growth across geographies, with particular strength in emerging markets. Within our segments, the Microsoft Business Division had another good quarter as businesses and consumers around the world look to Microsoft to meet their productivity needs. Six quarters post-launch, Office 2010 continues to exceed our expectation, with increased consumer and business PC Attach worldwide. We saw double-digit revenue growth across our key business application workloads, including Exchange, SharePoint, Lync and Dynamics CRM and ERP. As businesses large and small look to the cloud to lower costs and enable new ways of supporting a distributed workforce, they are turning to Microsoft. With Office 365, we give customers powerful productivity and collaboration tools at great value. Today, more than 100,000 businesses have made the commitment to our Online Services. Whether on-premise or in the cloud, Microsoft remains the top choice for productivity. The Server & Tools Business delivered another strong quarter, as we continue to execute on our strategy of cloud optimizing every business. CIOs are increasingly turning to our business infrastructure offerings, including Windows Server, Hyper-V and System Center as they look to Microsoft for the security, flexibility and manageability they need to build world-class private clouds. This quarter…

Thanks, Peter. First, I'm going to review our overall results, and then I'll move on to the details by business segment. Revenue for the quarter was a record $20.9 billion, up 5% or $900 million year-over-year. Operating income was $8 billion, cash flow from operations was $5.9 billion and earnings per share was $0.78. Foreign exchange did not materially impact our net income this quarter. Enterprise demand remains strong as our customers continue to add both product and seats to their Enterprise Agreement, and our renewal rates remain solid. At the end of the quarter, unearned revenue was $15.3 billion, and our contracted not billed balance was approximately $19 billion. Turning to the PC market, as I mentioned last week, it was a challenging quarter for the industry. Factors such as the flooding in Thailand, macroeconomic uncertainty and competing form factors resulted in an overall market that we estimate declined 2% to 4%. In the PC market, it appears that the impact of the hard drive supply chain constraints were not limited to a specific region or OEM type. While absolute volumes were impacted, we did see the following trends continue: PC sales to emerging markets outpaced developed markets; the business PC refresh cycle continued with business PC growth of 2%; the decline of netbooks negatively impacted consumer PCs which were down 6%. Netbooks, which a year ago represented about 8% of the PC market, now represents only 2%. Excluding netbooks, consumer PCs grew 2%. Now I'll move on to the results for the Windows and Windows Live Division, where revenue was down 6%. As usual, you'll find the OEM revenue bridge in our earnings slide deck. The primary differences between the PC market and Windows revenue were the continuing growth of emerging markets faster than developed markets and inventory…

Thanks, Bill. For the remainder of the call, I'll discuss our expectations for the third quarter and full fiscal year. Beginning with the Windows and Windows Live Division. We expect revenue to continue to be impacted by market dynamics similar to the past several quarters. PC growth in emerging markets will outpace developed markets, and business PC growth will outpace consumer PC growth. We also expect the hard disk drive shortage to continue to challenge the PC market to at least the next quarter. Turning to the Microsoft Business Division. For the third quarter and full fiscal year, transactional revenue, approximately 40% of the division's total, should lag the overall PC market, reflecting a higher mix of PC shipments to emerging markets. And multiyear licensing revenue, approximately 60% of the division's total, should grow low double-digits. Moving to Server & Tools. Approximately 30% of the division's revenues comes from transactional licensing, 50% from multiyear licensing and 20% from Enterprise Services. For the third quarter and full fiscal year, we expect transactional revenue to generally track with the hardware market, multiyear licensing revenue should grow low double-digits, and Enterprise Services revenue should grow high teens. Turning to the Online Services Division. We are focused on improving the financial performance of our Search business and are looking for ways to increase RPS and streamline costs. For the third quarter and full fiscal year, we expect revenue to show year-over-year improvements in RPS. Moving on to the Entertainment & Devices Division. We continue to be very pleased with our share of the worldwide console market. However, the console market is softer than we previously expected, and as a result, we now expect revenue to grow high single-digits for the third quarter and mid-teens for the full fiscal year. Switching to overall cost of…

Thanks, Peter. [Operator Instructions] Operator, please go ahead and repeat your instructions.

[Operator Instructions] Our first question comes from Adam Holt.

My question is about the material improvement in OSD margins quarter-on-quarter. It looks like you held firm on expenses year-on-year. Does that reflect the new philosophy around that business in terms of driving profitability? And can you update us on where you think you are on the RPS improvement?

Yes. As we've been saying, the key to profitability in that business is to grow our top line because it scales really well. The marginal impact of that is very high because it's a high fixed cost business. We have been, as we've been growing share and improving our RPS especially this quarter, holding the line on operating expenses and really streamlining. The most important thing long term, as we’ve said, is to continue to grow that share and grow the revenue per search, so we're pleased with that trajectory and want to keep on that. And we are watching the cost very carefully so that, that revenue marginally goes to the bottom line. And that's what you saw happen this quarter, and that's the trajectory we hope to stay on.

Our next question comes from Walter Pritchard of Citigroup.

We're just wondering on the EDD side. It looks like you called out the Nokia payments as part of COGS as a driver. And I'm wondering, you've been pointing us to mix of revenue types as mainly the driver there of COGS. Could you help us out with how meaningful those payments were? And how should we expect those to continue to track as we move into future quarters?

Yes, it's part of it. There were several things impacting the gross margins in the E&D business. Obviously, one is just the volume of consoles and the mix of consoles, high end versus low end, the mix of software whether it's first party or third party that has a different margin characteristic. And so that's the biggest piece in E&D. Then the Nokia piece is also another piece that plays into that. But the biggest piece is the mix of business in the E&D business and then Nokia is also another driver of that.

Our next question comes from Rick Sherlund of Nomura.

On the hard drive shortage issue, I spoke with Gartner on Monday, and they were looking for PCs of down 1%. You guys have said down 2% to 4%, and they helped reconcile that, suggesting that there were some issues in terms of the pipeline of products. And if the inventories were reduced in the pipeline, that might reconcile why the 2 of you are viewing the industry somewhat differently. I'm just curious if you think that's going to continue into the next quarter. I know we're going to see an impact in this next quarter. I'm just curious whether you and Gartner might be more in line with each other going forward? Or if there's more inventory reduction in that pipeline that might be an ongoing impact above and beyond perhaps what we're seeing from the numbers that Gartner and IDC are giving us?

Yes, that's impossible to say, Rick. I'd say obviously, for this quarter, we obviously are very confident and comfortable with the estimate as we said during the remarks. We expect the impact to continue on at least to the next quarter. And I think the best thing to do is at the end of that, we'll probably all have a better view and we kind of assess where we are and what it looks like going forward. I'd say just generally on the inventory as well, obviously, as I've said in my remarks, there was an inventory drawdown to end the quarter. I think there was an overall -- I think both IDC and Gartner have also talked about the fact that the overall supply chain for PCs is obviously leaner than it was 3 months ago. So we'll have to see how fast kind of people ramp back up, how fast the PC ecosystem rebounds, and that will obviously impact, as Peter mentioned, inventory at the end of the quarter as well. So good question.

Our next question comes from Heather Bellini of Goldman Sachs.

I was wondering, Peter, if you could talk a little bit about which businesses are the furthest along regarding their COGS transition as you move more and more of your revenues to the cloud, if you could kind of rank order them for us?

Yes, I'd say Office 365 is really far along. We've had a lot of good momentum and obviously, one of the things that drive -- you up the sort of margin scale -- is getting the economy to scale with volume, and we talked about some of the numbers, the 100,000 businesses the great sort of demand we've had for sort of the Office business all up including Office 365. So I'd say that's probably farthest along, followed closely by Windows Azure as we sort of add new enterprise customers, new ISVs, new developers to that. But certainly, Office 365 is accelerating at the ramp.

And the other thing that I would add is obviously OSD is, we'll call it, kind of our largest cloud property. And as Peter mentioned earlier, I think in one of the questions, it obviously has achieved scale. And as a result, kind of every incremental kind of search ends up becoming 100% margin. So we are -- we're at different stages, I think, within some of the different business products. But certainly around running a cloud infrastructure, we feel like we've got quite good handle on that from -- primarily from our Search business.

Our next question comes from John DiFucci of JPMC.

My question essentially follows to Rick. It has to do with the Windows OEM revenue bridge. Just curious on some of these items, how they fit today. For instance, and I believe, Bill and Peter, you take account for that inventory changes in the Windows Attach and inventory line. And last quarter, it added about 5% to the quarter. This quarter, it was a 2% hit. And Bill, you noted the inventory drawdown had an effect there. Can you give us a sense on where you think channel inventories are today relative to what you might call normal levels? And then also just quickly on that last line in that bridge, the OEM revenue adjustment, when is this stop -- going to stop being negative? It's been slightly negative for quite some time now. And shouldn't it have stopped like 3 years after the Vista launch because it -- wasn't it related to XP and having Internet Explorer as part of that as a meaningful part of that versus for Vista?

Yes, we'll take the second one first. Next year, that should go away. So to answer your question, yes, that's what you would expect and that's what will happen. On your first question on inventory, at any given quarter, inventory is going to be -- sort of go up and down depending on what's going on in the channel. As you noted, sometimes, it's a tailwind, sometimes it's a headwind like it was this quarter. It's hard to say precisely what sort of -- where it stands and what it's going to be like next quarter. We'll sort of look at it when we get there.

Our next question comes from Mark Moerdler from San Bernstein.

Question for you. How much of the year-over-year decrease in the consumer revenue on the Offices product is due to licensing, licenses specifically included in OEM sales of PCs as compared to stand-alone Office sales to the consumer market?

It's mostly associated with OEM. I mean, the driver that we use for that part of the MBD business is specifically tied with the PC unit growth of consumers. And so as I mentioned in my remarks, we actually outperformed that but that's the best driver that -- it's not complete but that's the best driver of trying to be able to predict or interpret that result.

Our next question comes from Philip Winslow of Crédit Suisse.

Just got a question on just the Windows division. When you think about the impact of Windows 8 coming out theoretically, obviously, the second half of this year, how do you think that's going to impact build plans amongst the OEMs but also inventory levels when we get to the summer?

Probably pretty premature to talk about that. I think we need to get closer to it. So the thing I would say is just from an ecosystem perspective, there's an incredible amount of excitement and innovation going on across vendors like the chip vendors and all the OEMs. You actually see that starting today with the Ultrabooks that you're seeing with Windows 7. And so the fact of the matter is there's a ton of innovation happening today for Windows 7. There's a ton of excitement for enterprises for both Windows 7 and looking forward to Windows 8, and what that gives them in terms of an end user experience and IT manageability. So I don't think about it so much as looking forward. There's a ton of innovation going on today. You see it in Ultrabooks. You see it in what both the ARM and x86 chip vendors are doing, and so that sort of continues sort of on a regular pace.

Our next question comes from Kash Rangan of Merrill Lynch.

If you look at the last few quarters, I know we've been through tough comps, sluggish slower revenue growth rate and also the mix issues that have caused the margins, the gross margins to go down. As you come out of this tough cycle and start to get into this, the next sort of launches, should we think about the gross margins as starting to go in the other direction just based on the -- what looks to be better mix between your Windows -- just typical software businesses as you get into launch year? Part of me it says maybe the margins are bottoming here. Of course, I completely respect the fact that you've got sort of another mix issues that are more longer term as you have Entertainment & Devices business, the cost there, et cetera. But shouldn't margins start to go back up as you head into launch year?

Yes. Certainly, margins are a function of mix. And to the extent there’s a higher mix and higher margin products, that will have a positive impact on margins. And it's not unrealistic to think that in a launch year, you can see a higher growth in higher-margin products. So it will depend on what the mix is, but I think it's a very plausible scenario.

Our next question comes from Brendan Barnicle of Pacific Crest Securities.

I was wondering if you could give us any color on what you saw geographically in terms of growth trends in particular or any -- in particular in Europe or Asia, it was weak or strong?

Yes. We saw a particular strength in emerging markets, particularly what we call the BRIC markets, Brazil, Russia, India and China. That was really a driver of growth for us. And that's exciting for us because we've had got strong and growing positions there, and that's where kind of disproportionate economic growth is happening sort of worldwide. But as Bill mentioned and as I mentioned, we saw a broad-based strength in demand across geographies but with particular strength in emerging markets.

[Operator Instructions] Our next question comes from Ed Maguire of CLSA. Edward Maguire - Credit Agricole Securities (USA) Inc., Research Division You called out 100,000 businesses that are engaged in Online Services. Could you comment on the impact that this transition is having on recognized revenues versus unearned and contracted not billed?

Yes, it's interesting. Subscription businesses aren't that much different from our existing multiyear licensing business in the sense that it sort of bills upfront and then recognized over time, just like our multiyear licensing agreements. And so it really doesn't have a significant impact on the sort of flavor or character of our revenue recognition or unearned revenue.

Our next question comes from Brad Reback of Oppenheimer.

Great. Peter, the business PC growth rate was down about 300 basis points sequentially. Was that all economic or hard disk drive?

Yes. I'd say -- the one thing I'd say is the overall business environment sort of remains very strong for us. And so sort of all of our sort of macro indicators for business spending on IT remain good, unearned revenue, our renewals for enterprise licensing agreements and sort of enterprise deployments of Windows 7. In terms of PCs, as we said, there's still growth and we're still in the refresh cycle. I do suspect that some of that, well, is due to supply chain and maybe a small amount due to macro but it's small.

Our next question comes from Gregg Moskowitz of Cowen.

Peter, you mentioned Ultrabooks earlier, and on the heels of CES, we're going to be seeing a lot more of them hit the market. Can you talk about what this means for Microsoft? And more importantly, when might Ultrabooks be ready for the mass market from a cost perspective?

What it means -- for me, what it represents is sort of the excitement and the opportunity long term in building compelling devices for consumers and businesses around the world. There's so much innovation still to get done. There's so many new form factors, so many new use cases. And I think it's great to see what the ecosystem does when it works together, as I mentioned before. In terms of the sort of price points in mass market, we'll just sort of wait and see how that evolves before commenting on that.

Our next question comes from Tim Klasell of Stifel, Nicolaus.

Just a question on the EDD. You have mentioned about a softening in the console sales. Do you think that, that's due to mix shifting towards lower-priced units, or is that business just getting more seasonal? If we model that going forward, should we make that a more seasonal holiday type of an event than we currently do?

In terms of the over -- first of all, yes, we feel -- for our console business, we feel really good about our sort of relative position in the market and our ability to take share and have a really strong competitive position. In terms of the seasonality, I don't think there's anything that indicates it's sort of more or less seasonal than we've seen in the past. Like many consumer businesses like this, it will always be relatively stronger at the holiday season. And in terms of some of the mixes, some of it's a function of product cycle. If you think about that Kinect centers and how we sold those into our installed base, and now we're selling more bundles, those kinds of things. Its seasonality hasn't marginally -- hasn't materially shifted.

Obviously, when big-title games come out, that tends to also drive kind of a big cycle so that’s also something to pay attention to around this business.

Okay, our next question comes from Robert Breza of RBC Capital Markets.

Bill, maybe could you just comment a little bit back on, I think it was a Crédit Suisse analysts talking about the Windows 8 release the end of February. Given the complexity you're adding into Windows 8 with mobile, et cetera, making that kind of a cross-platform experience, do you expect that to kind of delay the traditional milestones? Or how should we think about Windows 8 going forward?

Yes, I wouldn't think about kind of traditional milestones. I would say one of the things that Tammy [ph] talked about at CES last week was just how important it is for us to work on and with developers to create a really vibrant developer ecosystem. And so one of the things we also talked about with the beta release was the Windows Store, really making sure we're going to have quite a few apps that are going to be up on the Windows Store at beta. Obviously, one of the things she and Steve both talked about last week is that any Windows 7 PC could run Windows 8. But obviously, there’ll be kind of some new and interesting form factors that are going to come out here as we get further on down the road. So I don't know that I would think about it except, as we said earlier, we're on track. We feel really good about where we are on the product, and this next super important milestone is the beta release and having a really great developer ecosystem that kind of surround that. So great question. Okay, so that will wrap up the Q&A portion of today's call. We look forward to seeing many of you at the numerous conferences in which we're going to be participating at this quarter. For those of you unable to attend those events in person, you will be able to follow our comments at microsoft.com/investor. Please contact me or anyone on my team if you need the additional details. Thank you again for joining us today, and have a great afternoon. Bye-bye.

This concludes today's conference. Thank you for your participation. You may now disconnect.