Microsoft Corporation
Q1 2008 Earnings Call Transcript

Published: 26 Oct 2007

[Operator:]

Welcome to the Microsoft first quarter earnings conferencecall. (Operator Instructions) I would now like to turn the meeting over toColleen Healy, General Manager, Investor Relations. Madam, you may begin.

[Colleen Healy:]

Thank you very much and good afternoon, everyone. Thanks somuch for joining us today. This afternoon I am joined by

[Christopher P.Liddell:]

Thanks, Colleen, and good afternoon, everyone. Thanks forjoining us. I’ll start today’s call with highlights from our first quarterperformance and how we see the rest of fiscal 2008 shaping up. The first quarter represented an outstanding start to thefiscal year, with every part of the company performing at or aboveexpectations. In particular, we are very happy the consumer demand across ourtotal product range propelled revenue, operating income, and earnings per sharegrowth by 27%, 32%, and 29% respectively. Also, we successfully closed aQuantive and a number ofsmaller acquisitions, and we continued setting the platform for future growth withthe availability of products and services, such as an updated live search, BizTalkServer, Silverlight, Performance Point Server, Halo 3, and Office CommunicationServer. In terms of our financial performance, there are some keytrends that I would like to highlight. On the revenue side, the benefits of ourmulti-year product cycle are obvious. Q1 was our fastest growing first quarterin seven years, with revenue up 27%, or $3 billion, over Q1 of last year. Theperformance was across all positions, customer segments, channels, andgeographies. Looking specifically at the growth coming from our variousgeographies, emerging markets continued to be a strength. The nations that makeup the G7 grew 29% for the quarter, but even better was an over 40% increaseturned in by the combined group of Brazil, Russia, India, and China. A quarter like this demonstrates how enlarging ourgeographic presence has positioned us to benefit from the continued worldwideeconomic expansion. We also did a good job this quarter of converting revenuegrowth into profit growth. Operating income grew five percentage points fasterthan revenue, expanding our operating margin from 41% to 43%. Solid marketing and sales execution, combined withefficiency on operating expenses, kept costs in line with expectations. Earnings per share was up 29% over last year, up to $0.45,assisted by our ongoing share buy-back program. Given the start in the firstquarter, the acquisition of aQuantive, and an improved outlook, we areincreasing our revenue, operating income, and earnings per share guidance forthe year. We now expect revenue growth of 15% to 17%, and this wouldput the top end of that revenue approaching nearly $60 billion, representing a$2 billion increase over our guidance in July. We are also increasing our operating income and earnings pershare guidance, the latter to a range of $1.78 to $1.81, $0.08 to $0.09 higherthan our previous outlook. With those high level things for the quarter and 2008, I amgoing to turn the call over to Colleen now for more details on how we closedout the first quarter.

[Colleen Healy:]

Thanks, Chris. As Chris mentioned, we are off to the fasteststart for revenue and operating income growth of any recent fiscal year. Let meprovide you with details of our financial performance, starting with revenue.I’ll discuss top line financial and business momentum points and then follow upwith revenue performance for each of the business units. Then I’ll review therest of the income statement. All growth comparisons relate to the comparablequarter of last year, unless otherwise specified. Revenue increased 27% to $13.8 billion, significantlyexceeding our expectations by over $1 billion. Every business grew atdouble-digit rates, with particular strength in client, the business division,and server and tools, which grew in excess of 20% combined, as well as growthof over 90% by our entertainment and devices division. The underlying PC hardware market was strong, with estimatedgrowth of 14% to 16% during the quarter, about three points higher than ourexpectations. From a customer segment standpoint, the business PC shipmentgrowth rate increased almost three times to over 12%, while continuing to beoutpaced by the consumer segment. From a geographical point of view, PC growth rates inemerging markets continued to outpace that of mature markets, driven by robustgrowth in Brazil, Russia, India, and China, which grew a combined 20%. Europeand Canada led the mature markets, while we began to see recovery in the U.S.and Japan. Our mix of product billings for the quarter was approximately35% from OEMs, 25% from multi-year agreements, 20% from license-only sales, andthe balance from our other businesses. Non-annuity sales were particularly robust, which isconsistent with the post product launch stage for Windows Vista and the 2007Office system. Strong annuity licensing performance with enterprise agreementrenewal rates consistent with historical trends drove our unearned revenuebalance 15% higher to $11.6 billion. Our [contracted and not billed] balance increased sequentiallyto over $11 billion. When taken together with reported revenue, total bookingfor the company grew an impressive over 30%. I will close out the revenue overview by adding that changesin foreign exchange rates added about two percentage points to our overallrevenue growth and was slightly above our forecast heading in to the quarter. Now, I will provide revenue highlights by business segment,starting with client. Since Windows Vista became available for consumers,client revenue has grown over 20% on average. This quarter, a rapidly expandingpersonal computer market, progress against software piracy, and three quartersof Windows customers adopting premium versions drove client revenue to $4.1billion, an increase of 25%. OEM revenue, which makes up over 80% of client revenue, grew25%. After adjusting for three points of revenue recognition fromdeferred revenue, OEM revenue increased slightly faster then OEM unit shipmentsof 20%, due to a higher mix of Premium Windows SKUs. Consumer premium units grew over 150%, while businesspremium units grew closer to 11%. As a result, the OEM premium mix increased by16 points to 75%, driven by a 19-point increase in the consumer element ofpremium mix, and partially offset by a three-point decline in the businesselement. Because business premium SKUs have a five-to-one pricingimpact over consumer premium SKUs, these changes in the premium mix havelargely offset any impact to revenue. Client, commercial and retail licensing, which makes upabout 20% of client revenue, increased 23%, as business customers continue toadd client products to their annuity agreement. During the quarter, we saw a 27% increase in the clientvolume licensing portion of the unearned revenue balance. We view this to be apositive leading indicator of intent by businesses to deploy Windows Vista. Server and tools revenue increased 16% to $2.9 billion,driven by strong annuity license growth in Windows Server and SQL Server, whichwe are happy to see ahead of the upcoming new releases. More specifically, we saw healthy unit growth in our WindowsServer business, particularly in our premium enterprise edition SKU, which grewby over 35%. And SQL Server unit and revenue growth each exceeded 15%. During the quarter, we release Silverlight, a Windows homeserver. We also gained significant product development momentum with betareleases of Visual Studio and SQL Server. Since the availability of the initialrelease candidate of Windows Server about a month ago, it has been downloadedover 1 million times, indicating high interest in the coming final products. Our consulting revenue increased 32%, as we’ve experiencedhigher utilization rates following the recent business product launches acrossthe company. Online services business revenue grew 25% to $671 million,including $80 million for the half quarter of aQuantive revenue since close.Excluding aQuantive, consistent with the way we guided you back in July, growthwas in line with our expectations. Online advertising growth for the quartergrew 33%, or 25% before aQuantive. Microsoft Business Division revenue grew 20% to $4.1billion. As a result of our focus on delivering greater desktop value tobusiness customers, we achieved double-digit revenue growth across a broadrange of products within our Office system, unified communications, andbusiness solution areas. Looking at how the various customer segments performed,revenue from business customers jumped 25% over the prior year. We benefitedfrom strong, mid-market transactional sales and good Enterprise demand forbusiness productivity infrastructure, such as SharePoint and enterprise [COW]. Healthy sales through retailers for the back-to-schoolseason helped drive consumer growth in the quarter. Entertainment and devices revenue grew over 90% to $1.9billion, driven by higher-than-expected console sales and Halo 3, whichachieved the biggest entertainment launch day in history. The strong demand forHalo 3 generated approximately $330 million of Microsoft revenue in thequarter, as well as significant consumer interest for the X-Box 360 console. X-Box 360 console units increased over 90%, with over 1.8million units sold. This was driven by our August price cut, excitement aroundHalo 3 generating console demand, and an earlier ramp-up to the holiday seasonin anticipation of the most compelling line-up of game titles available on anyplatform. In addition to the success of Halo 3, X-Box 360 continues tolead third-party games sales against all current generation platforms, which isnot only good for us and our gaming audience, but also good for our gamedeveloper partners in the X-Box ecosystem. For example, according to NPD for the U.S., all four of thecurrent generation third-party titles in the top 10 last month were for theX-Box 360. Infact, over the last year, game developers have seen their titles hit the top 10list 27 times for X-Box 360 compared to only twice for the PS3 and only oncefor the Wii. This helps X-Box 360 software attach rates remain at record levelsfor any console at this stage in its lifecycle. Now for the rest of the income statement. Cost of revenueincreased three points to 19% of sales, primarily driven by the high volume ofX-Box 360 unit sales, increased consulting business, and expanded onlineservices operations. Operating expenses increased 11%, dropping from 43% of salesto 38% of sales. Expense growth was largely in line with headcount growth andis tracking to our expectations, despite the higher-than-expected revenue asgenerated during the quarter. Operating income grew faster than revenue at 32% to $5.9billion, exceeding high-end guidance by $750 million and expanding ouroperating margin by two percentage points. Investment income and other totaled $298 million for thequarter. Our effective tax rate for the quarter was 31%, half a point higherthan we previously guided. Cash flow from operations increased 45% to $5.9billion. Cash flow from operations outpaced operating income due to collectionson the large volume of business close at the end of the fiscal year. During the quarter, we repurchased 81 million shares, or$2.3 billion of company stock. $2.9 billion settled in the quarter due to thehigh volume of repurchases at the end of fiscal year 2007, and we paid out $938million in dividends to shareholders in the quarter. Diluted shares outstanding for the quarter were 9.5 billion,down 5% from the prior year as a result of share repurchases. Earnings pershare for the quarter were $0.45. So in summary, we are extremely pleased with this quarter’sperformance. Revenue for the fiscal year is off to the fastest start in recenthistory, fueled by strength across our products launched over the last ninemonths. Operating expenses came in line with expectations while generatingsignificantly higher-than-expected revenue. This resulted in operating incomegrowing faster than revenue at an impressive 30% clip. With that, let me turn it back to Chris who will provide youwith our second quarter guidance and outlook for fiscal 2008.

[Christopher P.Liddell:]

Thanks, Colleen. Before we get into the specific guidance,let me outline some of our key underlying assumptions. First, our fiscal 2008forecast assumes stable macro economic conditions through the remainder of thefiscal year. We remain optimistic about the overall outlook for the ITindustry. In mature markets, we haven’t seen a spillover from problems in otherareas of the economy, although clearly the risk of an economic slowdown hasincreased. Emerging markets in particular appear healthy to us. Notonly are we getting the benefits of strong growth offshore, but it is assistedby stronger international currencies. The FX impact alone we believe will addabout one point to our yearly revenue growth. Overall, our business is benefiting from our diversificationacross products, channels, geographies, and customer segments. We are increasing our expectations for PC unit growth forfiscal 2008 by one percentage point to 10% to 12% for the year, and 11% to 13%for the second quarter. Growth rates in both the Asia-Pacific and EMEA regionsappear to be stronger than we thought coming into the year. We estimate thatthe growth rate will continue to be higher in the consumer segment and thebusiness segment, and recent regional trends should continue with growth inemerging markets outpacing that of mature markets. Now let me go through our detailed guidance. For the fullyear, we expect our revenue to come in between $58.8 billion to $59.7 billion,growing 15% to 17%, up four percentage points from our last guidance. The full year forecast now includes revenue from aQuantive,which contributes approximately one point of revenue growth. The remainingthree point increase from July is driven by an improved outlook for our threebusinesses of client, the business division, and server and tools. For the second quarter, we expect revenue of $15.6 billionto $16.1 billion, which represents a year-over-year increase of 25% to 28%. With that, revenue guidance in our divisions is as follows

[Colleen Healy:]

Okay, great. Let’s proceed to questions. We want toaccommodate as many questions as we can from as many of you, so please avoidmulti-part questions and please limit yourself to just one question. Operator,can you please repeat your instructions?

[Operator:]

(Operator Instructions) Our first question comes fromHeather Bellini with UBS.

[Heather Bellini:]

Congratulations on the quarter. I was wondering if you couldgive us an update on your view of Vista adoption thus far, and in particular,how the uptake of premium SKUs, both on the consumer side and also with VistaEnterprise, are tracking versus your original expectations, and how should wethink about that going forward?

[Christopher P.Liddell:]

Clearly we are very happy with the client division overall.As you’ve seen since we launched Vista, the revenue growth has been in excessof 20% three quarters in a row, so the overall [headline] number, very good. In terms of the premium mix, also very happy about that.Now, in this case, premium mix brings in both Vista and XP premium sales aswell, and that’s tracking in the mid-70s, so 75% for the quarter, and thatcompares to I believe 59% in the equivalent quarter last year, so up 16 pointsyear over year. So we’re very happy with the adoption of Vista Premium and alsohappy with the old XP Media sales as well. The other thing I’ll point to is on the client annuityagreements, which is probably the best leading indicator we can think of ofpeople’s intention to adopt, that’s still very early in the adoption cycle forbusinesses, but the volume licensing portion of our business was up 27% in theclient area, so that’s a very good leading indicator from our point of view. And sort of finally, as a wrapper, year-to-date sales arenow 85 million units for Vista. That compares to about 45 million for XP overthe same period, so almost twice as much. So it’s still early days but progress, we’re very happy withso far.

[Heather Bellini:]

And just on the premium SKUs, would you say that they aretracking above what you guys had expected when you originally launched theproduct?

[Christopher P. Liddell:]

Yes.

[Heather Bellini:]

Great. Thank you.

[Colleen Healy:]

Next question, please.

[Operator:]

Our next question comes from Adam Holt with J.P. Morgan.

[Adam Holt:]

Good afternoon, and I’ll also let go the congratulations. Ihave two questions on the business uptake. In particular, you had a meaningfulacceleration on the client side in terms of business units and I was hoping maybeyou could detail what you thought was behind that acceleration. And then on the Office front, still another quarter ofbetter than 20% Office growth on the business front. Where do you think we areon the enterprise upgrade cycle for Office? Thank you.

[Christopher P.Liddell:]

Sure, Adam. We’ll start with client. The business saleswere, to be honest, a function of underlying demand, so the PC unit came in at14% to 16% for the quarter overall, compared to our expectations of around 10%to 12%, so we saw a good uplift in overall PC units, and that was both on theconsumer and the business side. I think the benefit that we saw on the business aspect wasprobably most particular in some of the emerging markets, so we saw goodstrength in business and that really helped us with the anti-piracy andlegalization aspect of our growth. So if PC units grew by 14% to 16%, ourshipped units that we were paid for grew by 20%, and all of that delta waseffectively a fight against unlicensed PCs, so the growth that we saw in thebusiness segment, in particular internationally, really helped us in terms ofoverall unit sales. So felt very good about that and we still think thatconsumers will grow faster than businesses, but overall a very good story onthe client side. In terms of the Office, that has a slightly differentimpact, mainly because it’s a much stronger impact from annuity there ratherthan non-annuity sales, although interestingly, non-annuity sales, whichtypically go to smaller businesses, were strong as well, which is a very directimpact with Office. In the annuity sales, which tend to have a multi-yearimpact, you recall I talked last quarter about how we saw a very strong sign-upfor maturing agreements right at the top end of our expectations, and that wasreally a very good leading indicator of people’s acceptance of or expectationthat they would roll out Office, but also the other products in MBD. So it’sclearly strong from our point of view that people are seeing not only a valuein Office, but products that are related to Office, for example, in the unifiedcommunications and business intelligence area. So overall, we’re feeling good about the rollout.

[Adam Holt:]

Terrific. Thank you.

[Colleen Healy:]

Great. Thanks a lot, Adam. Next question, please.

[Operator:]

Our next question comes from Sara Friar with Goldman Sachs.

[Sara Friar:]

Good afternoon, everyone. I think everyone is going to saycongratulations, but it is quite an amazing quarter you put up. Following onone more comment on the client Vista adoption side; I think a lot of folks hadthought SP1 would be the catalyst. Why do you think we saw it a little bitahead of that and do you have a timing update on SP1? And then I just have aquick follow-up question, if I may, after that.

[Christopher P.Liddell:]

Vista adoption, as I say, it is still early and I talkedabout intention to adopt rather than actual adoption. I think you are rightthat certainly some businesses will be waiting for SP1 to roll it out, but interms of their willingness to sign up for the client element of the multi-yearagreements, their intention to roll out is I guess signaled by that. So it isstill early days as to what the actual adoption numbers are, and we think itwill increase during the year and obviously will be helped to some extent bySP1. But some of the leading indicators are what we feel good about.

[Sara Friar:]

And then just turning to the EDD division, great quarter. Itseems like you do think there was some pull forward on consoles just based onyour guidance. Is there anything implied in your guidance on broader commentaryabout health of consumer spending in the fourth quarter? Are you leavingyourself a little bit more cushion there?

[Christopher P.Liddell:]

No, it’s principally around the pull forward, as youmentioned. And as I said in my prepared remarks, I tend to look at the businessfor the first six months rather than the quarters. In particular in the firstquarter, console sales were 1.8 million units, which is relatively small. So itwas ahead of our expectations, but it’s a quarter where you can beatexpectations because the volumes are small. I mean, Halo was obviously a clearbeat but in terms of consoles, I’d rather think that the volume over that sixmonths, because there’s a lot of stocking in anticipation of Christmas going on,and movements like that. So I feel good about it. There’s no particularsignaling on weakness for Christmas. In fact, we feel very good about theline-up we’ve got, not only from the box itself but obviously the gamesassociated with it as well.

[Sara Friar:]

Terrific. Okay, well, thanks a lot.

[Colleen Healy:]

Thanks a lot, Sara. Next question, please.

[Operator:]

Charlie Di Bona with Sanford Bernstein, your line is open.

[Charles Di Bona -Sanford Bernstein:]

I guess no surprise here, but I’m going to go back to thewell on OSB. It was probably the only division that didn’t really outperformsignificantly, only about 10% growth, excluding aQuantive, and the comScoreshare is back down to sort of the lows that they were in your fiscal Q4. Especially in light of yesterday’s announcement aroundFacebook, maybe you can give us a little insight into the strategy andexecution here, and is there any shift towards sort of buying traffic andcommunity rather than building it internally? And in general, how do you gobalancing those two alternatives and valuing those two alternatives?

[Christopher P.Liddell:]

First thing to note obviously is we met expectations, so itwasn’t a beat, I agree, but it was a meet, so start with that. Underlying business growth or revenue growth, you mentionedthe 10%, which is correct. Clearly in this case it’s a negative from the Accessbusiness going away, so -- if you look at underlying revenue growth, underlyingadvertising revenue growth, it grew in the mid 20s, around 25% for the quarteryear on year, which we think is acceptable. It’s nor certainly stellar. We’dlike to see it higher but it’s acceptable and it is higher than where we guidedat the start of the year, roughly speaking. So I think reasonable progress onthe organic side of the business. In terms of putting the building blocks in place and how wetrade off organic growth through inorganic growth, it’s both. The strategy hasbeen both and will continue to be both, so we are investing heavily in the organicaspects of the business, so a lot of investment in particular has gone into thesearch product itself, and we clearly are extremely happy with the improvementswe are seeing on aspects like relevance, which are critical going forward. Weare putting a lot of investment into things like data centers, which arecreating the platform of the future and the experience, so we are increasingCapEx quite considerably there. We are looking at CapEx overall for the year of$3.2 billion to $3.3 billion, about half of which is going into the OSB area.And we are putting investment in some of the verticals that I talked about onsearch organically and all the other areas as well, content on the displayside. So there’s a strong organic side, there’s a strong inorganicside, but clearly aQuantive is the most obvious representation of that andwe’re particularly happy that we not only closed aQuantive but we’ve retainedall of the employees. We think that integration has gone extremely well and webelieve that’s going to generate some significant benefits going forward. We also did some other smaller acquisitions, ones which wethink are important for the ad platform, like AdECN during the quarter, andthen the announcement yesterday on Facebook, which is a willingness on our partto make a commitment to a multi-year agreement with a partner who we think hasgot some tremendous growth opportunities. So we are willing to do both. We are quite clearly willingto suffer an operating loss in that position as a result of those commitments,and we’ll share that there I think both in our financial analyst meeting and inour guidance. But to date, in terms of underlying financial metrics, we’reon track. In terms of some of the other things that we wanted to do, if anythingwe are slightly ahead of where we would like to be.

[Colleen Healy:]

Thanks, Charlie. Next question, please.

[Operator:]

Our next question comes from Brent Thill with Citigroup.

[Brent Thill -Citigroup:]

Thanks. Good afternoon. Chris, I think your guidance for thefiscal year implies roughly a 40% operating margin, and clearly with Q1, it washigher than 40%. Why do you expect the operating margin will drift to thatlower level for the year?

[Christopher P.Liddell:]

Overall for the year, we feel very good about the operatingincome growth relative to revenue growth and it will still be an increaseyear-on-year. So there’s some COGS impacts, for example, the mix of COGS duringthe course of the year and we just saw an outstanding performance in the firstquarter, some really, really strong growth in particular in client and MBD. We think that out-performance is going to continue, but notat the same rate, so operating margins improve but I think quarter one was justan outstanding one in terms of our ability to take the revenue out-performanceand drive it to the bottom line, and as I say, there is a different COGS mix tothe rest of the year, which impact it as well. But overall margin, we are going to grow operating incomefaster than revenue growth this year, which means our margins are going toexpand, and the other impact which you know I’ve talked to you about is weexpect earnings per share to grow very fast as well, backing out all of theone-offs, if you like. We think EPS is going to grow faster than 20% this year,which is the benefit of the operating margin expansion and also the benefit ofthings like share buy-backs flowing through. So at this stage of the cycle for the company and for acompany that started to grow earnings per share greater than 20%, upsignificantly from where we were, we feel good about it.

[Brent Thill -Citigroup:]

And just one quick one, if I could; relative to enterprisedemand, it sounds like it’s improved slightly over the past couple of quarters.Do you think it stabilizes from here or has room to improve even from here?

[Christopher P.Liddell:]

It’s just the renewals. It was back to more traditionallevels in the first quarter and that’s about two-thirds of the three-quartersramp that we talked about, so we saw a particularly good renewal rate in thefourth quarter and we are back down to more traditional levels, but levelswhich we feel obviously very good about, so I don’t think -- we’re notexpecting an out-performance or an increase back to the very, very good levelsthat we saw in the fourth quarter, but if we can maintain traditional levelsand obviously start to sell the new product range that we have coming throughto our existing clients, and hence get the benefits of all of the additionalproducts that we’ve either launched or are going to launch, [that is up] verywell from a business point of view in terms of overall billings growth.

[Brent Thill -Citigroup:]

Thanks, Chris.

[Colleen Healy:]

Thanks a lot, Brent. Next question, please.

[Operator:]

Our next question comes from John DiFucci with Bear Stearns.

[John DiFucci:]

Thanks. Just a follow-up question I guess to Brent; themargins were really impressive here, Chris, and even next quarter, you have ameaningful increase in revenue and a pretty I guess meaningful decline inoperating margin. Is there any reason for us to think that you can’t do a lotbetter than what you are saying here? I mean, I understand what you are sayingabout the COGS, but it looks like it is something that can continue.

[Christopher P.Liddell:]

Probably the first thing to do is to normalize of aQuantive,so that may be distorting the numbers. But we are bringing that in for thefirst time and that’s bringing in revenue but no operating income -- in fact,with amortization of intangibles, it will be a slight loss for the year. Sothat’s probably a drag on the margins that you might want to normalize for, orat least give us the benefit of. If you take that out, the way that I look at it is what isour ability to meet our operating expenditure guidance and potentiallyoutperform on the revenue side, as opposed to drive the business on a marginbasis. And I would say I’m particularly happy with the fact that we deliveredincreased revenue in the quarter whilst keeping operating expenditure literallyright on guidance. You’ll recall from last year, I was certainly happy that wedelivered the whole year right on operating expenditures, so I feel really goodabout the business groups, discipline, the sales force discipline to a largeextent keeping operating expenses under control, which will allow us to, theextent that we beat revenue, to drive it to the bottom line. I can’t promise this is necessarily going to significantlyincrease margins, but it will increase margin every dollar that drops through,and perhaps if you back out aQuantive, that will give you a better comparison.

[Colleen Healy:]

From a fiscal year on fiscal year, I mean, if you arelooking at organic, fiscal year ’07 you were see us sort of a bit above themid-30s. You pull out aQuantive and legal charges and tax, guaranteed bonds andthe rest of it, for the year you are sort of in that 40% range, and then ofcourse, with Q2, given that X-Box with the hardware is such a big driver forholiday, Q2 for the year, in terms of for the year, you’d probably see a dip,but year on year, when you look at the true underlying organic, pulling outaQuantive and some of those other things, you are going to see I think prettygood margin there, John.

[Christopher P.Liddell:]

aQuantive will -- to help you, and obviously we’ll have togive more detail as we go on, but aQuantive will add $500 million of revenuefor the year. We will pull out deal costs and IP R&D that we write off ofclose to $100 million, but we’ll still leave in things like amortization ofintangibles, which we know other companies tend to call out. We’ll leave thosein, which means that will be a drag on the operating income of close to acouple hundred million towards this year. So perhaps that will help younormalize for that.

[John DiFucci:]

Thank you.

[Colleen Healy:]

Thanks a lot, John. Next question, please.

[Operator:]

Our next question comes from Kash Rangan from Merrill Lynch.

[Kash Rangan:]

Thank you very much. Good to see a quarter like that andmore particularly, the stock break out to a multi-year high. That’s got to lookgood. I just have a question on the online business, Chris. It looks likeyou’ve done a good job restoring or bringing profitability, let’s say, to theentertainment and devices business. At what point are we in making similarprogress on the profitability of the online business, especially with aQuantivebeing integrated into the operations of the company? And as a follow-up, I was also curious to get your thoughtson the client side. I know you do [inaudible], and correct me if I’m wrong, andthere’s some concerns in certain segments of Wall Street that there might be aninventory issue on Wall Street, especially on the PC side. Intel had a goodquarter, you guys had a good quarter, but with retail sort of weakening or atleast suspected to weaken during the holiday season, who knows, I’m justwondering if you share that concern and if you don’t, what specifically makesyou feel that this inventory build-up could actually lead to sell-through inthe Christmas holiday season? Thanks.

[Christopher P.Liddell:]

Entertainment and devices and OSB are really at differentparts of their business cycle. It was a very strong commitment from our pointof view to try and drive profitability in the entertainment and devicesdivision this year, and we feel like we are on track for that. So they are on,if you like an upswing to a part of their business cycle where we believe wecan be profitable. In the OSB case, there isn’t a primary driver of thebusiness at the moment. The primary driver is to invest in the right areas andcreate the platform for a very strong growth in economic value over the nextfew years. So it’s not one where we are the [clearly the] -- but if we wereprofitable, but it is one where it is not going to be our primary determiner ofsuccess this year. I will be keen to ensure that the expenses come in wherethey are. I’ll obviously be keen to see that our revenue growth is in line withexpectations, but assuming we meet those two things, it is going to be a lossfor the year. So they are just different -- the businesses are atdifferent parts of their business cycle, and so we have different tests againstthem. On the client side, we are not seeing any significantinventory issues that we are aware of, and so from our point of view, if youlook at the guidance, we feel good about PC unit growth guidance of 11% to 13%.Anything in double digits or greater we think is good and that’s like a sell-innumber, using your terminology. So we think that’s good and we think we shouldbe able to drive OEM units in our area around that same level. So there’s noparticular issues of significance that we are aware of.

[Kash Rangan:]

It just looks like the emerging markets and the [inaudible]countries, perhaps business there is accelerating and that’s why your OEM unitsare looking better than they have in the last few quarters?

[Christopher P.Liddell:]

That’s absolutely right. Those countries really did anoutstanding job -- countries like Russia, the business overall grew there bygreater than 100% in the OEM area and client grew by something like 50%. Sosome of those countries are growing at a tremendous rate, which is a functionof the underlying economies growing well, but as we see business growth inthose areas and a greater desire to obviously have legitimate PCs, we areseeing good progress on piracy as well, and that’s really helping us with ouroverall OEM unit.

[Kash Rangan:]

Great. Thanks a lot.

[Colleen Healy:]

Thanks a lot, Kash. We have time for one, maybe two more questions,please.

[Operator:]

Our next question comes from Kirk Materne with Banc ofAmerica.

[Kirk Materne:]

Thanks very much. Chris, I might be jumping ahead a littlebit here, but clearly you guys haven’t seen any slowdown in terms of demandaround either SQL Server or Windows Server 2008 in front of those launches. Whatis your expectation in terms of the impact of those launches on the growthrates? Do you think that we’ll see demand come in at a steady pace? Or do youexpect that as we get into the back half of the year, that can help acceleratethe growth rates in that division? Thanks.

[Christopher P. Liddell:]

I think it will help continue the growth rates that we’veseen, to a large extent. You have to realize that the structure of our businessreally has matured significantly to one that’s driven much more aroundmulti-year expectations. So people are -- to the extent we’re seeing strengthin annuity agreements now, it’s an anticipation of those products. The factthose product launch won’t in itself drive an enormous amount of accountingactivity. We’ll see that over a slow -- to a large extent, that’s the samephenomena we talked about with Vista. These things will happen over time aspeople adapt and adopt the particular systems. But from a revenue and economic point of view, ourrelationship with our customers, our ability to continue to sign them up anddrive growth is much more of a multi-period rather than a single event basedphenomena, and we just think a continuation of very strong products rolling outcontinuously quarter after quarter, year after year, is the best way of drivingthat business.

[Kirk Materne:]

Just a really quick follow-up on Windows Server 2008, thebeta for Veridian is still expected to be released with that, with thefull-blown version released 180 days afterward? Is that still on track?

[Christopher P.Liddell:]

Yes, that’s correct.

[Kirk Materne:]

Thanks very much.

[Colleen Healy:]

Great. Thanks so much, and our last question, please,Operator.

[Operator:]

Our last question comes from Brandon Barnicle from PacificCrest Securities. BrandonBarnicle - Pacific Crest Securities Thanks so much. I just have two quick ones. Chris, first onpremium edition, obviously a great move, year over year up 75%. As we have SP1come, where we potentially get more enterprises pulling in, can we see thatpremium edition even move up higher still? And then secondly, over on aQuantive, have you given anythought again to the agency business and whether that’s something that stayswithin the business or needs to be divested? Thanks.

[Christopher P.Liddell:]

Yeah, we are very happy with XP business. That’s continuedto do a great job. I mentioned before, I think the integration has goneextremely well. As far as we can tell, the employees are very happy, who arerunning the XP business in particular on a standing independent basis andreally letting them continue getting on with their life. We think it is a verygood business and no intention to do anything other than continue to run it. On the client side -- just go over your question again,sorry.

[Brandon Barnicle -Pacific Crest Securities:]

Premium edition, 75%, very impressive. Can we see it go to85%?

[Christopher P.Liddell:]

We’re just looking -- in terms of our guidance and ourthoughts and what’s embedded with, we believe we can continue to drive that atover 70%, but too early to predict anything higher than that.

[Brandon Barnicle -Pacific Crest Securities:]

And would SP1 have any impact on accelerating that?

[Christopher P.Liddell:]

It might help but those rates of 70% are very high, so -- itmight assist but it may just simply just help us continue at that sort of rate.So we are not [anticipating] a particular pick-up as a result of that alone.

[Brandon Barnicle -Pacific Crest Securities:]

Thank you very much.

[Colleen Healy:]

Thanks, Brandon, and thanks everyone for joining us today.If you have any further questions, please feel free to call me or my teamdirectly. As I mentioned at the beginning of this call, this conference callwill be available on replay at our investor relations website through close ofbusiness October 25, 2008. In addition, you can hear the replay by dialing800-835-8067, or for international calls, please dial 203-369-3354. The dial-inreplay will be available through the close of business November 2, 2007. Thanksagain, everyone, for joining us today.

[Operator:]

And that concludes today’s call. Thank you for joining.