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Microsoft's Red Ring warranty conference call transcribed

Following yesterday's announcement that Microsoft would be expanding their warranty program to cover the Red Ring of Death issue for up to three years from the purchase date -- at a cost of $1.05 to $1.15 billion -- we tuned into their conference call with Robbie Bach, President of Entertainment & Devices Division, and other Microsoft executives. We've transcribed the call for your edification:

Robbie Bach: Good afternoon everyone. Thank you for joining us this afternoon. I want to update you on the things we're rolling out across the Xbox 360 Before I get into the details of the announcement I want to give you a quick snapshot of the Xbox business. Overall the fundamentals of the business remain very strong. Our games attach rates remain the highest in the industry as seen at this stage in the console's life cycle. Xbox Live continues to add members and we're selling lots of games. If you look at customer recommendations, about 90% of our customers recommend our product to friends. And we're getting ready to go to E3 where we'll show what we believe to be the best slate of games the industry has ever seen. So the fundamentals are good.

Having said that, there's one area of the business that we care deeply about and where quite frankly we're not doing a good enough job. Over the past couple of months, the number of repairs to Xbox 360 consoles has been unacceptable to us. Following a thorough investigation into the issue and ongoing testing, we've identified several factors that can cause general hardware failures which are indicated by three flashing red lights on the Xbox 360 console. We've already made improvements to the 360 [inaudible] and reduced the occurrence of these issues going forward. We are implementing some important incremental policy changes that are geared toward both short term and long term satisfaction of our customers.

Specifically, we are implementing an enhanced warranty program to cover the general hardware failures indicated by the three flashing red lights. While we will still have a general one year console warranty -- and that console warranty is two years in some countries -- we are announcing today a specific three year warranty for any console that displays the three flashing red lights error message. If a customer has an issue indicated by the three flashing red lights we will repair the console free of charge including shipping for three years from the console's purchase date. Microsoft will also retroactively reimburse any customers who paid for out-of-warranty repairs related to this error message in the past.

In doing so, Microsoft stands behind its products and takes responsibility to ensure that every Xbox 360 owner continues to have a great gaming experience. I want to ensure all of our Xbox 360 customers that today's announcement is not any sort of product safety issue; this is a completely voluntary decision on our part that underscores our commitment to our customers. The majority of customers continue to have a terrific experience with Xbox 360 and we want them to play with confidence that Microsoft stands solidly behind our products. Obviously this action requires a financial investment on our future. Here to discuss the financial implications is Chris Liddell.

Chris Liddell: Thanks, Robbie. I'm going to briefly walk through the financial impact of our announcement today. To start, the issues and related customer service initiatives Robbie discussed earlier will result in a $1.05 billion to $1.15 billion pre-tax charge to our fiscal fourth-quarter earnings. It will be in the cost of goods sold line in the income statement and we will call the amount out specifically in the quarterly earnings so you have visibility into our underlying business. In arriving at this charge, we completed a comprehensive analysis which included key assumptions around factors such as expected Xbox 360 return rates, average repair cost per unit, and the ability to [inaudible] units. As with any charge of this nature it is an estimate and we will monitor actual experience against our assumptions on an ongoing basis.

The charge is made up of two components which are roughly equal in size. The first is related to our current warranty program. While the impact of higher return rates and higher average repair costs are included in this component, the majority of this amount is driven by inventory valuation adjustments. The second component is for the specific three year warranty that Robbie discussed earlier. I'd also note that [inaudible] today console sales at the end of June were approximately 11.6 million units but the charge also covers the cost to repair more consoles that are being produced to date.

Clearly, I'm disappointed in the result from a financial perspective; however, I agree that consumer satisfaction is a top priority for Microsoft so we have decided to make the investments necessary to provide a great experience for our customers. We also believe that the initiatives announced today strengthen the long-term value of the Xbox business by giving customers the security of knowledge that we stand behind our products.

Lastly, I would like to comment on the impact on FYI guidance. We do not expect the changes announced today will have an impact on the Entertainment & Devices division's fiscal year '08 financial outlook. The long-term fundamentals of the business remain strong and we're maintaining our goals of FYI profitability of both the Xbox business and the Entertainment & Devices division overall. Also, we do not expect the decision announced today to have any impact on our overall fiscal year '08 guidance which we will provide on our earnings call later this month. With that, I'll know hand the call over to Joe so that Robbie, Frank Brod, and I can field you questions.

Joe: Thanks, Chris. Let's now proceed with questions. Please restrict your questions to items covered in our announcement today and hold all other earnings-related questions until our call on July 19th.

John DiFucci (Bear Stearns): I was wondering Chris if you can tell us the timing of the cash impact we might see. I assume it's over the three years but do you have some estimates on the timing of the cash impact of this charge? And I just want to clarify that you said 11.6 million units by the end of June. I believe your goal was 12 million. Are you saying that you didn't hit your goal as far as units shipped?

Chris Liddell: Starting with the last question first. Yeah, we are talking about 11.6 million units to date and and tk from the approximately 12 we were looking for by the end of the year, so that is slightly shy but in the overall context -- I don't know if we can comment more a little bit later -- yeah we're happy with that number and clearly that's the number we're referring to today. From a cash flow perspective, yes. It will, theoretically, be over teh three-year period we're talking about but clearly we would expect it to be more in the shorter-term than the longer-term so we're providing three years as a security for people. Some of the boxes have already been sold so we're partially through that three year period and to a large extent, the cash flows will be through the next year to eighteen months.

David Hilal (Friedman Billings Ramsey): A question on how many units have been affected out of the 11.6 million and is there a problem that's completely behind it?

Robbie Bach: Yeah, so we're not going to discuss, nor have we historically discussed, return rates or specific numbers of units. Suffice it to say that with a billion dollar charge and the focus we're putting on this that it's a meaningful number. It's one that we take very seriously and one that clearly has our attention. In terms of going forward, we do feel like we understand the issues and have made the changes needed to dramatically reduce this problem going forward and that we think we have our hands around it at the engineering level, which is the important thing for us clearly to do. And in fact, as Chris inferred, if you look at our fiscal year '08 expectations those are on track with what we said in the past and that's because we feel comfortable with where we are on the engineering side.

John Taylor (Arcadia): I wonder if you could expand a little bit on the 50/50 split and how you're allocating this – I'm particularly interested in your comment about inventory evaluation adjustment. Does that mean you basically have to take what's in the barn and rework it; and so that's an additional cost or ...? Could you go into that a little bit more?

Chris Liddell: Yeah, sure. The 50/50 is 50% associated with the existing warranty program, so it's any repairs associated with the warranty that we already have, and 50% is on the extension to three years. So that's the overall 50/50. With respect to the first 50%, there are inventory adjustments associated with that. And that will be essentially two-fold. That will be the repair costs associated with any inventory that we have now to get to the standard that we require; and also to the extent that we need to write off some units that we feel that we can't sell for a price less than the cost of repairing – then we made a provision for that as well. So both of those elements are in the inventory costs.

Alan Cook (Merrill Lynch): This product's been out for a little over 18 months. Can you tell us when the problem became apparent? Is it something that's just cropped up over the past few months? Or has it been around for the full 18 months?

Robbie Bach: Well, for a little over the first year, this problem – this set of issues – wasn't visible at all. It's the type of problem that doesn't happen because you turn on the 360. Sometimes you have hardware problems the first time you turn something on and you have a problem right away. These aren't those types of problems. So for the first year-plus it was something that wasn't, frankly, really on our radar screen. But in the last couple of months, we started to see significant increases in repair requests, significant call volume, and significant attention from people. And so we geared up to respond to that appropriately. It is one of those challenges in terms of figuring how you can test for things that happen a year to 18 months into the life cycle of a product; it's the type of testing that we do today and we're gonna do obviously more of that going forward.

Charlie Debona (Sanford Bernstein): I was wondering if you could comment on whether this was a design issue or an assembly issue. And to the extent it's an assembly issue, do you have any recourse to your manufacturers?

Robbie Bach: You should think of this as an issue that's Microsoft's responsibility. The partners who have done assembly and component work for us have done good work; we're very proud of working with them; we're going to continue to work with them. So you should think of it as a Microsoft design issue. Again, since it's multiple things, I hate to even point at design. To get at the heart of your question, it's really our responsibility, not anybody else's.

Charlie: And so is this something that you've now been able to engineer?

Robbie: Yes.

Tim Klasell (Thomas Weisel Partners): I want to go to how you mentioned that you still expect full-year profitability despite a fairly significant charge. What else has changed in your business that you're able to absorb a billion dollar charge? Has it been the games attach rate? Or is I just gonna be much lower operating margins with the division, but still profitable?

Chris Liddell: Just to clarify, the charge will be in the fourth quarter this fiscal year and the reference to profitability is the one we talked about at the financial analyst meeting last year, which referred to the fiscal year '08... So you are comparing two different periods when you make the question. In terms of fiscal year '08 and the impact of this on that, we still [inaudible], simply because that's based on an expectation of the number of units that we sell, the attach rate that we sell with the lineup of games that we have, and the manufacturing cost of units that we intend to manufacture from here. So to a large extent they are unaffected. In fact, we hope that by giving the security that we are giving today to customers, their confidence in buying products next year from Microsoft will be certainly confirmed if not enhanced.

Robbie Bach: Lemme just add a little bit on the business side of that – if you set this aside just for a quick second, the general progress we've been making on costs and our ability to manage the economics of the business has been very positive, and we're very pleased with that; and that is consistent and on track with what we've been forecasting all along. That really does help us. The second thing I'll say is – and you'll see this for those of you who are at E3 next week – the games lineup we have for next fiscal year, I think is certainly one of the best in game history, if not the best. And there are those four letters called 'H-A-L-O' coming in September. With Halo 3, we're very, very excited – the buzz around that game is very positive. So I think the fundamentals of the business remain very strong. It's part of the reason why we want to make sure our customers can buy with confidence because we think we're actually in a very good position strategically.

Tim: Okay, well maybe I can clarify the question just a bit. Because if I divide, let's say, $500 million over install base of 12 million, you're having about a $40 impact per console out there. Do you think this charge will cover all of that, and then going forward would you have corrected anything on your sales going forward, so that there will be no impact on operating margins on the support?

Chris: Yeah, the review that we have been doing is exactly that. There are a number of variables which go into it, clearly. But what we are doing is making assumptions about the overall charge that we believe is appropriate, so that it won't impact things going forward. That's exactly the intention with the charge that we're taking.

Kirk Materne (Bank of America): Chris, I think you've sorta answered this, but when you had looked at the '08 you looked at from the economies of scale you're gonna get from a manufacturing standpoint, I assume none of the reengineering that had to be done to correct some of these problems has impacted those assumptions? Or has the impacted them, but you've seen other things on the business line that still make you fell confident about the projections for next year in terms of margins?

Chris Liddell: Yeah, it really didn't have a material impact on manufacturing costs going forward and if anything we've been [inaudible] on this particular problem, which is obviously significant. The progress that we've been making on the manufacturing side, we're very happy with. So the overall costs per unit manufactured going forward, we feel good about.

Kevin Buttigieg (AG Edwards): Just to be clear then, in response to one of the earlier questions, the increase in the warranty, I would assume that that would have some impact on your revenue recognition on Xbox next fiscal year. Wouldn't an extra warranty, for example, require a little bit lower revenue recognition for that extra cost?

Frank Brod: No, we are setting up reserves based upon the repairs that we expect, but the revenue recognition itself doesn't change at all. We'll still be selling the Xboxes to the consumers on the same terms, just as we've been doing so up until now.

Chris: And to be clear, clearly, with the Xboxes that we're now manufacturing, even though the warranty is for 3 years, that's as much a security blanket, if you like, rather than an expectation. We expect it to be a very good performance going forward, given the corrections we've made in the manufacturing process.

Kevin: Okay, and then this charge is obviously pre-tax, but there should be a benefit, so to speak, from it, as well, I would imagine?

Chris: From a tax perspective you mean? (Laughs)

Kevin: Okay, but you're not obviously providing guidance for that right now. Is there some variability around what that could possibly be?

Chris: Not huge. No, we're simply just giving the pre-tax number. If you apply the expected tax record we've got for the year and the number is outstanding depending on what assumption you make on the buy back that we do during the quarter, then we're talking about a 7-8% per share impact. But that will vary depending on the model that you're using.

Kevin: Okay. And then just finally, last December I believe it was, you extended the Xbox warranty from 90 days to a year. Is this charge also part of that announcement as well?

Chris: We've been incurring some costs during the course of the year, both for the repairs that we've done to date and that; and this is over and above that.

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