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Microsoft's Downbeat Outlook

Microsoft CEO Steve Ballmer Kimberly White/Getty Images

There was little optimism in remarks by Microsoft (MSFT) executives when they reported fiscal third-quarter results on Apr. 23. Chipmaker Intel (INTC) had said the PC business had bottomed when it announced earnings on Apr. 14. A few days later, IBM (IBM) gave investors glimmers of hope that the economy may be turning around. And whole divisions of Apple (AAPL) seemed to shrug off the recession entirely when the company's results soundly beat analysts' estimates on Apr. 22.

Microsoft, the world's largest software maker, is seeing no such rays of sunshine. In an Apr. 24 call with Wall Street analysts, Microsoft Chief Financial Officer Chris Liddell sounded downright morose. "We remain more cautious than most," he said. "While we'd all like to hope that the recovery will be short and painless, we unfortunately think it will be slow and difficult."

The numbers show why. In the fiscal third quarter ended Mar. 30, the company suffered the very first year-over-year sales decline in its history, with revenue slipping 6% to $13.65 billion. For starters, Microsoft is feeling the effects of a recession that has depleted demand for PCs. Businesses are hitting the brakes on new computer purchases, and many consumers are opting for new, low-cost netbooks that carry an older version of Windows that costs less than half the amount Microsoft gets for software on a full-featured PC.

Tough Slog in New Markets

Then there are the competitive pressures Microsoft would be facing even if the economy weren't contracting. Apple is siphoning off business in the market for more expensive PCs. And while Microsoft saw brisk sales of its Xbox game console, it's making little headway in other efforts to crack new markets, including smartphones, TV systems, and online search and advertising.

To its credit, Microsoft is taking pains to deal with this new reality. Thanks to the first big layoff in company history, Microsoft managed to match Wall Street's earnings expectations of 39¢ a share, excluding 6¢ in one-time charges related to the layoff and the falling value of some of its equity stakes in other companies. Investors drove Microsoft shares up 3%, to 19.50, reflecting satisfaction with the company's plans to slash an additional $700 million from operating expenses in the quarter ending June 30. This includes cutbacks in bonuses and travel expenditures and the elimination of 1,100 jobs last quarter.

Microsoft CEO Steve Ballmer is also hoping to revive growth with a slew of new products. Jeffries & Co. analyst Katherine Egbert says the next version of Microsoft's operating system, Windows 7, may come relatively soon and possibly in time for the back-to-school shopping season. That might help the company reverse the 15% sales decline in the $15.5-billion-a-year division that includes Windows. Microsoft will also unveil a new version of its Windows Mobile software for smartphones in an effort to keep pace with Apple, Research In Motion (RIMM), and other players in the still-healthy market.

A New Search Offensive

Coming next year is a new version of Microsoft Office, the flagship product in Microsoft's very profitable productivity-software business. Microsoft is also expected to launch a new version of its Internet search service in coming months, to keep pace with archrival Google (GOOG) and stem losses in its Internet division, where the quarterly loss widened to $575 million, from $226 million a year earlier.

How much these new products will help remains a matter of debate. Sure, Windows and Office are under pressure in part because existing versions of the products are growing long in the tooth.

But larger, structural industry trends will probably continue to take a toll on Microsoft, even after new products appear and the economy improves. The company says 10% of PC sales this quarter were netbooks, the stripped-down computers often priced at less than $500. Microsoft appears to be girding for continued demand for the machines, judging from a new strategy to sell bare-bones and more capable versions of the operating system on its PCs.

Gloomy Prospects for Online Services

"The cautious spending and preference for lower-priced PCs are fundamental shifts in the marketplace that will not dissipate once the economy improves," writes Allan B. Krans, an analyst with Technology Business Research. "As seen with Vista, Microsoft was running Windows under the 'bigger is better' strategy, and the current recession is driving customer behavior in the opposite direction."

Changes will also come to the company's healthiest units. The server and tools division, which sells gear used by corporations to run IT operations, saw fiscal third-quarter sales rise to $3.4 billion, from $3.2 billion. Over the next few years, Microsoft is introducing a technology called Azure that's designed to give companies more flexibility in how they run IT operations. But it's a major strategic shift that won't be easy to pull off—and won't bring in big revenues until 2011, Liddell says.

The company's beleaguered Online Services division continues to have the most pessimistic outlook. Even if the company manages to cut an alliance to combine its search efforts with those of Yahoo (YHOO), many analysts fail to see a strategy that would help make a dent in Google's growing market share and influence. "In the last four quarters alone, Microsoft's operating losses in [Online Services] were $2 billion," writes TBR's Krans. "Although [Online Services'] losses represent a small portion of Microsoft's revenue and profit, the company's time and effort could certainly be better spent elsewhere."

Burrows is a senior writer for BusinessWeek, based in Silicon Valley.

Burrows is a senior writer for Bloomberg Businessweek, based in San Francisco.

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