Welcome to the Microsoft 2007 fiscal year second quarter earnings conference call. (Operator Instructions) I would now like to turn the call over to Ms. Colleen Healy, General Manager, Investor Relations. Please go ahead.

Thank you. Good afternoon, everyone and thank you for joining us today. This afternoon I am joined by Chris Liddell, Senior Vice President and Chief Financial Officer and John Seethoff, Deputy General Counsel. Today's call will start with Chris providing some key takeaways for the second quarter of fiscal year 2007 and an overview of expectations for the rest of the fiscal year. I will then provide detail around our second quarter results, and then turn it back to Chris for a more detailed discussion of our guidance for the full year and the third quarter of fiscal 2007. After that, we will take your questions. We filed our 10-Q today in conjunction with our earnings release. Therefore, you have available the earnings release, MD&A, financial statements and footnotes. We have also posted our quarterly financial summary slide deck, which is intended to follow the flow of our prepared remarks in order to assist you. The slide deck offers highlights from the quarter, outlines our guidance and provides a reconciliation of differences between GAAP and non-GAAP financial measures that we will talk about today. You can find the earnings release, the 10-Q and the quarterly financial summary slide deck on the Investor Relations website at www.microsoft.com/msft. Today's call will be recorded. Please be aware that if you decide to ask a question, it will be included in both our live transmission as well as any future uses of the recording. As always, shareholders and analysts can listen to a live webcast of today's call at the Microsoft investor relations website. A replay of the call will be available at this same site through the close of business on January 25, 2008. This conference call report is protected by copyright law and international treaty. Unauthorized reproduction or distribution of this report, or any portion of it, may result in civil and criminal penalties. Any recording or other use or transmission of the text or audio of today's call is not allowed without the express permission of Microsoft. We will be making statements during this call that are forward looking. These statements are based on current expectations and assumptions that are subject to risks and uncertainties. Actual results could differ materially because of factors discussed in today's earnings press release, in the comments made during this conference call and in the risk factors section of our 10-Q, our 2006 Form 10-K and other reports and filings with the Securities and Exchange Commission. We do not undertake any duty to update any forward-looking statement. With that, let me now turn it over to Chris.

Thanks, Colleen and good afternoon, everyone. We are pleased to be with you today to share our second quarter results and discuss our outlook for the remainder of fiscal 2007. Looking back over the second quarter, I would characterize it as a very good close to the first half of the year, and it continues our progress for an excellent year overall. All aspects of our financial performance came in at or above the high end of our guidance. We were happy to see the PC hardware market strength in the quarter. And, by launching our flagship products to business customers at the end of November, we passed the last significant milestone towards forward availability. Looking at our second quarter financial performance, revenue grew 6%. If you were to exclude the $1.6 billion revenue deferral associated predominately with our technology guarantee program for Windows and Office, our revenue growth would have been 20%. That is impressive growth for any company, let alone one of our size. Business customer demand for our server and tools and Microsoft business division products was healthy across major geographies in both our large and small customer segments. Looking specifically at sales in December, we saw encouraging signs of early demand for the 2007 Microsoft Office system, Exchange Server 2007 and Windows Vista. Retail demand during the holiday quarter was robust for consumer PCs as well as for Xbox 360 consoles and games, helping to push revenue for both client and entertainment and devices to the upper end of our quarterly guidance. Operating income benefited from both the strong revenue as well as lower spending, primarily on marketing programs, most of which shifted out of quarter 2 and into the rest of the year. The operating income results flowed through the P&L and drove EPS numbers that came in $0.02 to $0.04 above what we told you in October. Moving to the full fiscal year, 2007 continues to deliver excellent financial performance. Next week, we celebrate the consumer launches of Windows Vista and the 2007 Office system. Our product groups will have put in significant work to deliver what are truly compelling products, and now our customers can benefit from those efforts. Let me make two key points about fiscal 2007. First, I'm very pleased that we continue to expect full year double-digit revenue growth. Overall, this is in line with what we told you last quarter, although we are making some adjustments to the mix of revenue. Second, excluding legal charges and tax benefits in the prior year, we expect earnings per share will also grow double-digits and faster than revenue. This growth is even after we launch the major products and continue to invest in future growth opportunities in all our divisions. With those high level themes for the quarter and for the full year of 2007, I'm going to the turn the call over to Colleen now for more details on our second quarter performance.

Thanks, Chris. As Chris mentioned, Q2 was a strong quarter overall, contributing to a good first half of the fiscal year. During the quarter revenue, operating income and EPS exceeded the high end of our guidance and we continued executing on our product cycle, with the business launch of Windows Vista, the 2007 Microsoft Office system and Exchange Server 2007. Let me provide you with details on our financial performance, starting with revenue. I will discuss top line financial and business momentum points and then follow up with revenue performance for each of the business units. All growth comparisons I mention relate to the comparable quarter of last year, unless otherwise specified. Revenue for the quarter was $12.5 billion, up 6%. Growth for the quarter was impacted by $1.6 billion in revenue deferrals out of Q2 that will be recognized in Q3, primarily related to the Windows and Office Technology Guarantee Program. The deferral amount is up slightly from the $1.5 billion that we previously guided, driven by strength in the PC market. Adjusting for these revenue deferrals, revenue growth would have been 20%. Revenue growth for the quarter was driven by a 76% increase in entertainment and devices and robust growth in our core businesses of client, server and tools, and the Microsoft business division, which grew a combined 11% after adjusting for the deferrals, primarily from the tech guarantees. Healthy growth in the hardware market was a key contributor to the results for the quarter. We estimate the PC market grew faster than we expected at 8% to 10% during the quarter. This growth is particularly strong, considering the upcoming consumer launch of Windows Vista, illustrating the success of our Tech Guarantee Program, as well as the continuing value proposition of Windows XP. Consumer PC shipment growth once again outpaced business shipments, driven by a strong holiday sales season. From a form factor perspective, growth in notebook PC shipments continues to outpace that of desktops. PC unit growth continues to be led by the emerging markets. Asia, excluding Japan, and Latin America maintained double-digit growth rates, while the remaining regions grew at single digits. Server hardware shipment growth remained consistent with our full year estimate of 10% to 12%. Our mix of products billings was approximately 30% from OEM, 25% from multi-year licensing agreements, 20% from license-only sales, and the balance from our other businesses. Relative to prior year, our billing mix continues to shift to our other businesses, driven by the increasing revenue from our entertainment and devices divisions. We had a very strong quarter overall from a volume licensing perspective, with broad-based strength across our customer segments and regions, which drove growth in enterprise agreements, as well as select and open annuity licenses. We estimate that EA renewal rates were at the high end of our historical range of 56% to 75%. In addition, select and open license-only growth accelerated in December after the business launches of Windows Vista, the 2007 Office system and Exchange Server 2007. Our unearned revenue balance ended the quarter a bit higher than we expected at $11.9 billion, including the $1.7 billion of deferrals primarily related to the technology guarantees. Excluding this impact, the unearned balance would have grown 15% over the prior year and still have been up sequentially. Our contracted, non-billed balance at the end of December was also sequentially higher and now exceeds $9.5 billion. If you consider our reported revenue and changes in the unearned and contracted, non-billed balances, our bookings growth exceeded 20% for the quarter. Before I get into the revenue details for each business group, let me point out that changes in foreign exchange rates added about 1 point to our overall revenue growth rate. Client revenue of $2.6 billion, a decline of 25%, includes the impact of $1.1 billion of revenue deferrals, primarily related to the tech guarantee. Adjusting for this impact, Client revenue would have been $3.7 billion, up 9%, driven by growth in the OEM business. OEM revenue increased 8%, excluding the tech guarantee, due to 10% growth in OEM license units. OEM revenue grew at a slightly slower pace than license units, due to the continued increased volume in emerging markets and the shift in channel mix towards larger OEMs, partially offset by the impact from the increase in premium mix. OEM premium mix increased 18 percentage points from the prior year to 67%. Consistent with the relative strength in the consumer segment, especially during holiday, and deferred by the technology guarantee program, we saw a shift within the premium mix itself. Specifically, the growth in the premium mix was a result of consumers purchasing Windows XP Media Center, driven by the upgrade pricing structure offered under the technology guarantee program. So while Windows XP Professional grew year on year, its portion of the premium mix declined a couple of percentage points. While we are delighted to see the increasing trend of consumers recognizing the value offered in premium Windows, we want to point out to you that in the U.S., Windows XP Professional generates over five times the pricing uplift over Windows XP Home than does Windows XP Media Center. Client commercial and retail licensing grew 13%, primarily from sales of Windows Vista into the retail channel, and our partners began readying for Windows Vista general availability. Our commercial business remained healthy, fueled by growth in multi-year contract agreements. The client business made significant progress on the product front this quarter with the business launch of Windows Vista, the most significant operating system release since Windows 95. Server and tools delivered double-digit revenue growth for the 18th consecutive quarter. Its 17% revenue growth was driven by broad adoption of our server and tools product line, particularly SQL Server, which had another quarter of over 30% revenue growth. Revenue for our online services business grew 5% to $624 million, driven by an increase in advertising revenue of 20%, partially offset by an expected decline in access revenue. Healthy growth in display, coupled with a modest increase in search, drove the rise in the total advertising revenue. Increasing search queries contributed to search revenue growth on a year-over-year basis for the first time since we began our transition to AdCenter in the U.S. last year. Microsoft business division revenue was $3.5 billion, or $4 billion after adjusting for the $500 million tech guarantee and preshipment deferral. Growth was driven by the strength of our annuity business and earlier than expected uptake in our license-only business following the business launches of the 2007 Office system and Exchange Server 2007. The Dynamics business continued its strong performance in Q2, as demonstrated by a 19% increase in customer billings. Lastly, entertainment and devices growth of 76% for the quarter was driven by Xbox 360 sales. We have now sold 10.4 million consoles life to date. And according to NTB, consumers in the U.S. purchased more Xbox 360s than both the Wii and PlayStation 3 combined during the month of December. Software attach rates remain at record levels in the U.S., bolstered by the broad success of Gears of War, which sold over 2.7 million copies in its first eight weeks in market. Our mobile and embedded device business also performed well, selling over 3 million licenses for Windows mobile phone-enabled devices, up over 90% year over year. During the quarter, we launched the Zune digital media player in the United States, which furthers our strategy of connected entertainment. Now for the rest of the income statement: positive revenue increase 62%, due primarily to an increase in Xbox 360 sales. As a result, gross margin relative to the prior year was down about 10 percentage points, a slightly larger drop than the guidance we provided in October. This was primarily driven by stronger than expected sales of Xbox 360, as well as an extension of the Xbox 360 warranty from 90 days to one year in the U.S. and Canada. Q2 operating expenses other than cost of revenue increased $509 million or 10%. This was a little higher than expected, due to the timing of certain spending, particularly for sales and marketing programs. Operating income was $3.5 billion. Adjusting for the tech guarantee deferrals, operating income would have been $5.1 billion, up 10% from the prior year, driven by strength in our core businesses. Investment income and other totaled $333 million. Our effective tax rate for the quarter was 31%, up from 29% last year. This year over year rate increase was impacted by a $108 million tax benefit in the prior year. During the quarter, we repurchased 205 million shares or $6 billion worth of our stock and paid $980 million in dividends to shareholders. Diluted shares outstanding were 9.9 billion, down 7% from the prior year, as a result of execution on our share repurchase program. Our diluted shares outstanding for the quarter were impacted by the issuance of 113 million shares in December related to options exercised by JP Morgan for the employee stock option transfer program completed in December 2003. This settlement marks the final expiration of all remaining options under its program. Earnings per share for the quarter were $0.26, which includes approximately an $0.11 per share deferral, primarily from tech guarantees. So in summary, Q2 delivered strong results across the board. Revenue results for all of the segments met or exceeded the top end of our guidance and translated to out performance for both operating income and EPS. Additionally, the quarter marked the business launch of our flagship products. With that, let me turn it back to Chris, who will provide you with our expectations for Q3 and the remainder of fiscal 2007.

Thanks, Colleen. Before we get into the specific guidance, let me outline some of our key assumptions. Our fiscal 2007 forecast assumes no major changes in the economic conditions from where we exited the first half, and we're not forecasting any significant impacts from foreign exchange rate movements. We expect PC unit growth to be 8% to 10% for the fiscal year, in line with the guidance we gave you last quarter, and between 9% to 11% for the third quarter. We continue to estimate the PC unit growth rates will be higher in the consumer segment than in the business segment, and higher in the emerging markets than in mature markets. On the server hardware front, we remain comfortable with our estimate for total market price of 10% to 12% for the year. Now let me get into our detailed guidance. For the full year, we expect our revenues to come in at $50.2 billion to $50.7 billion, growing 13% to 14%. We are narrowing our revenue range to reflect how we finished the second quarter, as well as to incorporate changes to the mix of revenue. Our growth is driven by broad-based revenue growth across our five segments, with each of our core businesses growing double-digits. For the third quarter, we expect revenue of $13.7 billion to $14.0 billion, which represents growth of 26% to 28% year over year. Our third quarter will benefit from recognition of the $1.7 billion of revenue that we deferred out of the first half, $45 million from Q1 and $1.64 billion from Q2, primarily associated with our technology guarantee program. Before these impacts, third quarter revenue guidance would have been $12 billion to $12.3 billion, which would have represented growth of 10% to 13%. There's clearly no impact to the full year, as we have discussed. With that, revenue guidance in our five business units is as follows: For client, we have increased our full year growth forecast to 11% to 12%, up from the 9% to 10% we gave you in October and this has been driven by a higher premium mix in our OEMs revenue and a faster transition to Windows Vista. We expect third quarter growth to be 54% to 56%, although our third quarter guidance includes the recognition of approximately $1.2 billion in revenue primarily associated with our tech guarantee program. Before that deferral, third quarter revenue would be growing 16% to 18%. Growth accelerates in the second half of the year for the commercial and retail portion of the client segment, beginning in quarter 3, driven by broad availability of Windows Vista. Client OEM revenue should grow roughly in line with the PC hardware market for the year. We are increasing our expectation for premium mix in the second half of the year and we now expect our full-year premium mix to be about 60%. The increase is driven by mix assumptions for our consumer premium products such as Windows XP Media Center and Windows Vista Home Premium. As Colleen mentioned earlier, we have received modest revenue upside from our consumer premium SKUs versus what we get on Windows XP Pro or Windows Vista Business. Server and tools revenue should grow 16% to 17% for the year from continued growth of SQL Server, development tools and our enterprise services. Revenue for the third quarter should also be up 16% to 17%. We forecast revenue in the online services business to grow between 3% and 8% for the year and 4% to 10% in quarter 3. Although we're still forecasting growth in search queries and page views, our plans now include a more measured rate of growth for the balance of the year. Our full year forecast anticipates total advertising growth in the mid-teens, and we expect this to be driven in particular by our display business, which is growing at a healthy rate, as we see good page growth in our key properties. We continue to have high aspirations to grow this business and we will continue to invest in the business during the second half. Microsoft business division revenue should increased 10% to 11% for the year, an increase of 2 percentage points from the guidance we gave you last quarter on increased business uptake of the 2007 Office system. Q3 revenue should grow 27% to 28%. Our third quarter revenue guidance includes the recognition of approximately $0.5 billion of revenue deferred from the second quarter related to our tech guarantee program and 2007 Office system preshipments into the channel. If you were to adjust for that impact, revenue growth for quarter 3 would have been 13% into 14%. We are encouraged by the favorable customer response we saw in December surrounding our new products. In the entertainment and devices division, we are pleased with what we have been able to accomplish in the past year, including achieving our goal of having sold over 10 million consoles life to date, outselling competitive next-generation consoles during this holiday season, achieving record software attach rates and reaching 5 million Xbox Live members. With that strong momentum, we are making tradeoffs and choices in managing the Xbox business to achieve our targeted profitability in fiscal year '08. In the near term, this means we will optimize for profitability. We believe this puts us in a strong market and financial position as we go into fiscal 2008, a year that will feature a number of catalysts, highlighted by the strongest first and third-party game lineup we've ever had. As we look at historical seasonality, pricing and inventory levels, we're taking a more cautious view of the market, and our half 2 revenue and console guidance reflects that. We are now forecasting full year revenue growth of 26% to 31% and a decline of 15% to 25% for the third quarter and expect to exit June having sold about 12 million Xbox 360 units since launch, down from our previous guidance of 13 million to 15 million. That reduction in console units also results in a reduction in revenue related to attached software, accessories and Live. Moving on to operating income, for the year we expect to generate between $19.3 billion and $19.7 billion of operating income, representing growth of 10% to 12%, excluding legal charges taken in fiscal 2006. This is an increase of approximately $200 million on both the low end and high end, this is what we told you in October, now representing double-digit growth even at the low end. We are flowing through some of the revenue upside and keeping full year spending in line with what we had in October. For the third quarter, we expect operating income to be between $6.1 billion and $6.3 billion, including the impact from revenue recognized from our tech guarantee and preshipments. Excluding this impact, operating income for the third quarter would be between $4.4 billion and $4.6 billion. Third quarter operating income includes some costs deferred from the second quarter, as well as operating costs in preparation for the launches of Windows Vista and the 2007 Office system. Cost of goods sold as a percentage of revenue for the full year should increase by 1 percentage point over last year, in line with what we said in October. We continue to estimate a full year tax rate of 31%, consistent with what we saw in the second quarter and with our October guidance. Diluted earnings per share, we're bringing up the range for the year by $0.02 at the low end and $0.01 at the high end due to higher revenue in our core businesses of client, server and tools, and MBD. This translates into a full-year expected range of $1.45 to $1.47 and $0.45 to $0.46 for the third quarter. The third quarter earnings per share includes approximately $0.12 per share associated with the impact of the tech guarantee program. From a balance sheet perspective, we expect unearned revenue to finish fiscal 2007 up 6% to 8% due to our better performance in Q2. Contracted not billed should also finished 2007 up from where we exited fiscal 2006. When thinking about sequential changes in unearned revenue from quarter 2 to quarter 3, we expect a decline of slightly greater than $1.7 billion of revenue we'll recognize associate with our tech guarantee program and presales. This decline would be consistent with normal seasonality. For our full year unearned revenue guidance, we're modeling a moderation in the recent annuity mix of our billings as both the 2007 Office system and Windows Vista will be available to customers in the second half of the year. I'll remind you though, as you think about guidance for the rest of the year, we still face the risks and opportunities I have highlighted in our previous two earnings calls: for example, competitive, legal, execution and general market risks; as well as PC and server hardware growth rates, customer acceptance of our products, and the costs to remain competitive, such as those to acquire and serve customers in our online businesses. Also, our emerging businesses are harder to forecast when compared to our mature businesses, so as they continue to become a larger part of our overall financial mix, they may contribute to increased volatility in our quarterly performance. Before moving to questions and answers, I would like to make a couple of quick comments. I committed to you at our financial analyst meeting last year to provide you with a more continuous flow of information throughout the year, and that would include communication from Steve and me. We will do that on February 15 in New York City, and for those of you unable to join us for that, we will make available a live webcast as well as an on-demand replay of the presentation. The intention of this presentation is for Steve and me to meet with investors and provide an update on our strategic direction after completing our internal strategy meetings. Although we may generally discuss revenue and spending trend levels, we will not give any detailed financial information. As in past years, we will provide our first preliminary review of fiscal 2008 guidance on our third quarter earnings call in April. Since the financial analyst meeting in July, we have also had executives out talking with the financial community in a variety of forums at a pace over once a month outside of our quiet periods. Looking forward into half 2, we will double that frequency. In general, we have been trying to give you more overall exposure to all of our senior executives and we look forward to seeing you. With that, I'll hand the call over to Colleen so we can get started with some of your questions. Thank you.

Thanks, Chris. Let's now proceed to questions. We want to accommodate questions from as many people as possible, so please avoid multi-part questions and please limit yourself to just one question. Operator, will you please repeat your instructions?

(Operator Instructions) Your first question comes from Heather Bellini - UBS.

Good afternoon, Chris and Colleen. I was wondering if you could give us your assumptions for higher price SKU mix in the March quarter, because if we adjust for the technology reversal that you are going to have in March, then it appears that you're looking for client segment growth of roughly 20% versus a PC shipment forecast that is about half that. The second question I would have is that for Service Pack 1, it typically comes out one year after the release of Windows, if we look back historically. I'm just wondering if we should be thinking less than that now, given your desire to shorten Windows development cycles.

In terms of the quarter 3, if I work through the math of taking you from the shipment units that we see down to the revenue, that will probably help you the most. And then I will talk about service packs. As I mentioned in the formal remarks, we expect shipments in the third quarter to be 9% to 11%. We are assuming that our units that we sell will be at the top end of that range, 11%, so we'll still have a modest improvement. The main factor that is going to drive the revenue is going to be on the commercial and retail. So we will, again as I mentioned in the prepared remarks, we will certainly get a significant impact from that element of the revenue that is commercial and retail. As you'll recall, that's only about 20% of the total revenue but we're expecting it to grow significantly relative to the previous year, obviously, with Vista being available for the first time. So those will be, in essence, the main drivers. You are right, that will get us up to revenue growth that is close to 20% for the quarter.

On the service pack side?

On the service pack side, Heather, we have seen a lot of the same rumors that you probably have in the press in terms of dates. The company hasn't put a date out there. It always makes sense to see how the product does out of the gate, continue to get feedback and we don't have an SP date to share with you today.

Your next question comes from Charlie DiBona - Sanford Bernstein.

Hi, Chris. I was wondering if we could turn to the online services business. It looks like the display ads are doing fine, but search is slipping share pretty consistently in all the independent numbers. You have now lowered guidance, it looks like while you might be growing search a little bit you are certainly going to continue to slip share if you stick to this guidance. How should we be looking at this business? How can we evaluate progress here? When can we expect a turnaround?

You are right, Charlie, to break the business down into its different bits. Clearly, the overall results are impacted by adCenter decline. but if I take that out and look at the advertising revenue overall, it grew 20% for the quarter, which we're happy with. If you break that down into display and search, clearly there is a better story on the display side, and we are growing broadly in line market. So I'd like to think we can put a tick in that box and we are comfortable with the progress we are making there. On the search side, you are correct that we lost market share certainly relative to the independent assessment during the quarter, and are clearly not happy with that. We continue to take a long term view of this business. We continue to invest in it, and we are making progress in the short term on some of the factors that we think are important: getting advertisers onto our adCenter platform, turning the corner in terms of revenue on a quarter-by-quarter basis. Since we went off Overture, the second quarter is the first quarter where we are seeing consecutive growth in revenue and we still expect to get revenue per search equal to where we were a year ago by the end of this year. So we are making progress in some of the underlying factors and we are continuing to invest. But I expect you should and we should expect to see more progress in the long term on the search side.

Does there come a time when you can share some of those metrics you say are doing better internally? Because we don't see them out here.

From a communications standpoint, Charlie, what we've really set up is at our financial analyst meeting there are some specific metrics that we told you you will hear, really from Kevin Johnson: breadth of usage, depth of usage and how we're doing on monetization, really similar to our competitors in terms of providing some of those underlying drivers quarter by quarter. It is not something that we are doing, it doesn't necessarily make sense from a competitive standpoint. There tends to also be pretty decent third-party information out there. But you will continue to hear from the business leaders, as well as Chris, directly at FAM on those metrics that we outlined at the financial analyst meeting last year, and we'll update you again on at least a yearly basis.

Charlie, the other thing I would say is once we lap coming off Overture you'll be able to do a much better comparison because then we are comparing ourselves to ourselves. So in two or three quarters I think the comparables year on year will be much easier for you to make an assessment of progress. Also, as the impact of the access business decline becomes much less significant, then you are really looking at the underlying business growth. So it won't necessarily get to the level of granularity that I know you have consistently been looking for. But I think it will become, hopefully, more useful to you.

Your next question comes from Kash Rangan - Merrill Lynch.

Hi, thank you very much. Just to clarify the Xbox commentary, Chris, is that more of an inventory flush-out that causes you to lower the guidance for the rest of the year? Also, if you could comment on the premium mix. If you experience better mix shift to the higher-end versions of Vista after the launch, will that cause the company to raise its guidance for the client business or is that already factored into the guidance? That’s it, thanks.

On the Xbox side, certainly the healthy inventory that we have seen which is partially a result of the very good sales that we saw into the channel in the second quarter last year, is one of the factors behind what we're looking for in the second half. Also, as we start to think about fiscal year '08 and what's the best approach to take for fiscal year '08 in terms of profitability, so we're just making some strategic decisions around what we might do there, too. So it is those two things, broadly speaking, which are the reasons why we are giving the guidance we are. On the premium side, we have embedded inside the guidance that we have given you the premium mix that we now have of 60%. So that is reflected in the guidance for fiscal year '07. Clearly, as Colleen mentioned, inside that 60% there is a mix within a mix, so depending on how that came out between the consumer SKUs and the business SKUs, if that changed, the 60% could still be the case, but we could have a different revenue number there. But at this stage, based on our expectation of the premium mix and how the business and consumer elements of that were made up, that is reflected in the guidance.

So you are not assuming any change in the business versus the consumer within the premium as it relates to '07 guidance just as yet? You're basically using the same experience as with XP to make your forecast, right?

It is not the same experience as XP. It is the same experience, if you like, as what we forecast at the beginning of the year.

Your next question comes from Rick Sherlund - Goldman Sachs.

Thanks. Chris, the launch of Vista, Office 2007 and Exchange Server coming up at the end of this month, if I want to be a little more optimistic about the revenues in Q3, you've given a little bit of precise guidance there and I'm just not sure how predictable the demand is going to be. I'd just ask you to talk to that issue in terms of your ability to forecast for Q3, given the launch of some pretty major new products and whether you might think it reasonable to think that we could see more upside in Q3.

Richard, we've talked about it before, I think this is different from if you go back a decade, obviously, to a Windows 95 impact. We certainly think it would be positive, but more gradual as it rolls out into the marketplace. In terms of the impact on overall sales, we were heartened by the quarter 2 results. We are certainly heartened by the fact that the tech guarantee appeared to avoid any stalling of sales in that quarter. But we are sticking with the external numbers that you have seen and that is flowing through in turn to our second half. Could there be some upside to that? Yes, clearly there is, but obviously there could be some downside as well. I talk about that on the risks and opportunities side. If the product was extremely well received and if there was very strong demand at say the top end of our expectations for the second half, clearly that would flow through. At this stage, it is launching next week, and we're taking what we consider to be just an appropriately conservative view of the second half.

SQL Server up 30%-plus again this quarter against a launch last year of the new product, I'm a little surprised that we are continuing to see 30%-plus growth from that product, particularly on a tougher comparison. Any light you can shed on what is happening or why we're seeing such robust growth there?

Yes, we were positively surprised on the upside there, too. The only thing I would say is that the price increase went in during the quarter. So you've got some part of the quarter which is price impacted, if you like. So it will definitely become a much harder comparable in the second half. But in terms of underlying sales, it was a good quarter, you are right.

Chris, on the Xbox, just finally, I hear what you're saying that you want to manage inventory levels down it sounds like, over the next couple of quarters. Certainly if there were a price reduction coming, you would want to minimize your channel inventory levels before you would do something like that. Am I understanding correctly that what you're trying to do is manage inventory levels down for Xbox in the second fiscal half?

I wouldn't put it in those terms. We are looking at the numbers that we sell into the channel based on where we see the inventory at the start of the year and the patterns of sales that we think will come up. So the net result of that may well be that we see inventory come down. But if you like, it is an outcome, not a management of that.

You're not seeing any change in the competitive environment; there's no change in your assumptions of market share?

No.

Your next question comes from Adam Holt – JP Morgan.

Good afternoon. You made a number of comments about the ASP and premium mix expectations around Windows. I was hoping maybe you could talk a little bit about what you are expecting within Office. Obviously, you have got a number of new SKUs with Small Business Pro/Ultimate. What does the guidance imply in terms of ASP improvement and what do you think is reasonable for us to expect?

Well, to the extent that obviously we're just giving guidance for the balance of this year it is not a huge impact. There is clearly revenue coming through from the first half which is not significantly impacted by that and so there is not a huge impact in the whole of fiscal year '07. Having said that, we did see renewal rates, as Colleen mentioned, at the top end of our 66% to 75% historic range. One of the reasons for that we feel was people anticipating the Office and therefore being attracted to renew. So that, to some extent, flows through in the second half. But in terms of an overall mix shift, it's not a significant component of the fiscal year '07 revenue.

If I could just ask a follow up on the strength in unearned, what I was particularly taken with was the client side. If you net out undelivered, it looks like you had better than 30% growth in client unearned. Could you talk about what you are seeing in terms of enterprise renewal activity, reattachment to enterprise licensing, and maybe refresh us on your thinking in terms of what you're expecting for enterprise adoption as we get further into the cycle?

On the annuity side, as with Office, a bit with client as you're talking, we have seen really nice renewal rates. They have been really trending at the high end. In particular, to your point, when you look at the various parts going into unearned, we are seeing a bit of an uptick in terms of customers adding Windows under their enterprise agreements. We think the value proposition from the enterprise view is compelling. And of course, you can only get if you are an annuity customer, so that looks promising. But really, I would say at this point, a bit too early to get ahead of ourselves. But we have been noticing that a bit as well.

Thank you. Your next question comes from Brent Thill - Citigroup.

Thanks. Chris, just a follow-up to Adam's question on Office. The reviews have been very solid, and just wondering if you could help us understand what the rationale is, why pricing can't go up in the face of that, considering this is a pretty big release. If you look at the server business, you have raised pricing and it doesn't feel like there has been any pushback.

What we could say on the pricing side, actually, is certainly in terms of the upper end views, we have put more value into those offerings. For example, on the Professional Plus offering, which adds the Communicator IM Client and other things, pricing went up a bit, call it 5% or so. On the enterprise SKU, which has Pro and Windows and grew, we did take the opportunity to add more value there. We expect to see some pricing uplift there. So really what you're seeing, whether it is SQL or Office or some of the other products you mentioned, it is really more SKU differentiation that you heard from us really at the financial analyst meeting a year ago, and we are really continuing to look for opportunities to provide value in higher-end SKUs and price accordingly. But again, we don't want to get too far ahead of ourselves in terms of adoption rates. Keep in mind that a lot of these products, in particular on Office, because there's already quite a bit going into annuity, you actually recognize that over a period of time on the P&L.

From our perspective, at a particular price point, the concept of increasingly trying to add value at that price point over time through software development is just a good philosophy. So we certainly don't think just because we are adding functionality that we should necessarily increase price. In terms of our renewals now in the post-Vista and Office era, the ability to actually offer new products and hence look at enterprise agreements that are much broader, much more of infrastructure-based agreements rather than desktop agreements, is more of the potential.

Your next question comes from Jason Maynard - Credit Suisse.

Hi, guys. I have a question on spending. You had indicated that Q2 was a little lower than expected in marketing program spend. Server and tools, I think, did $1 billion in op income. How do you think about Q2 in terms of its impact on spending in the back half of the year and even longer term as you look to invest in places like online services and then even potentially in entertainment devices?

We have kept, again, our expenses very much in the context of the year and we have kept our expense number for the year the same as where it has been essentially all year. I am increasingly happy with the discipline we are showing there for the year. In terms of the quarter-by-quarter movement, we certainly give the people flexibility on a quarterly basis to spend on programs as is necessary. We can see swings, in particular in some of the marketing spends with some of the launches on a quarter-by-quarter basis. So I wouldn't get too concerned one way or the other. In this case, it's a positive trend on the expenses year to date. I tend to focus on what our expectations are for the year and at this stage, they haven't changed.

Maybe just help me reconcile, operating cash flow came in just a touch above $2 billion, which was a little lower than I think most of us were modeling. Can you maybe help us understand the puts and takes on the cash flow number?

To some extent, there was obviously inventory builds. We had a relatively high number of Xbox sales and so that does tend to impact our cash flow for the quarter. There could well be, depending on the line you're looking at, the big billings area. So a big unearned can influence the cash flow aspect of it as well. But there were no significant issues. Buyback was relatively high, but we also had the JP Morgan options exercised, so nothing unusual there. I would describe it as a reasonably predictable cash flow quarter, albeit with some big movements inside it.

Thanks so much. We have time for a just a few more questions. Our next question please.

Your next question comes from Robert Breza - RBC Capital Markets.

Hi, good afternoon. Real quickly, Chris, maybe as a follow-up to the last question, when you look at the leverage you showed this quarter and a little bit of lack of spending in the back half of the year, where do you see additional leverage coming from? What levers do you think that are there that you could execute to deliver upside?

Well it's more likely to be on the revenue side. Clearly, we have the opportunity to cut expenses and some of the decisions that we can make, we could, for example, decide to cut back on marketing for the second half of the year. I don't think we will, but we could do it. The upside potential really comes more on the revenue side and that really comes across the board. So clearly, in our client and office division, as Rick's question alluded to earlier, with a launch there's a big amount of variability around that. So there could be some upside there. But we've guided to what we think is probably the appropriate level. In the online services area, there's probably not such a big swing factor there in the overall context of the company, but clearly our ability to continue to generate display advertising and change market share in search has some impact. And then on the entertainment and devices, really it's to a large extent on the revenue side, it is an Xbox story. Again, we have taken what we think is the most likely scenario there. Given the relative seasonality, the June half is a lot less significant than the December half in the Xbox business, so I don't see a high degree of variability. But again, that would be something that would be a big factor. Each of the businesses has their own dynamic. But if you're looking for the things that could swing, it is really in our core businesses with those big launches.

Great, thank you, nice quarter.

Your next question comes from Tim Klasell - Thomas Weisel Partners.

Going to Vista, you've mentioned in the past that you won't be having to hold back the 5% to 25% going into deferred. That should be about $150 million to $250 million a quarter as that rolls off the next three years. Is that the right way to think about that, and is that still the way you plan on doing it?

We had quite an extensive discussion last quarter about that. I think we stated that we will give you guidance for fiscal year '08 in our next quarter in terms of exactly how much we expect from that. We want to be transparent about how much is the underlying business, how much is simply just the different revenue recognition. It will be order of magnitude in the sort of numbers you're talking about, but it is too early at this stage to give actual numbers out.

Good. One final question, Longhorn, if we look out a little further, how is that tracking and are you still planning on an end of the year release?

Yes, we are.

Longhorn is tracking. We are expecting really to RTM for the second half of calendar year 2007 and I think you'll hear more from us over time on that. Great, thanks so much. We have time for one last question, please.

Your final question comes from John McPeake - Prudential.

A question about online offering and dynamics [inaudible] Could you talk a little bit about how Codename Titan, the online product, is going to roll out and the timing there?

You are little faint there, sorry. But I picked up your question in terms of Titan, have we gone public on the timing for that?

We have.

That's the summer this year. So we are on track for that, as we talked about. So that will be in the summer, in six months, if you like.

Does Xbox inventory drawdown have anything to do with potentially a new version of Xbox coming out first fiscal half?

No. That was an easy one.

Great. Thanks a lot, John. Thank you, everybody for your participation in today's call. If you have any further questions, please feel free to call me or my team directly. As I mentioned at the beginning of this call, this conference call will be available on replay at our investor relations website through close of business January 25, 2008. In addition, you can hear the replay by dialing 800-873-5569 or for international calls, dial 203-369-3995. The dial-in replay will be available through the close of business February 2, 2007. Thanks again for joining us today.

Thank you.

Thank you. This does conclude today's conference call. We thank you for your participation.