Microsoft Slams on the Brakes

Two days after President Barack Obama, in his inaugural speech, told the country to brace itself for tough times, the head of one of the most valuable U.S. companies echoed the sentiment. "We're certainly in the midst of a once-in-a-lifetime set of economic conditions," Microsoft (MSFT) Chief Executive Steve Ballmer told analysts during a conference call discussing fiscal second-quarter results. "The economy is resetting to a lower level."

In other words, we've entered a new paradigm. The mortgage-market collapse, financial market turmoil, and restricted lending have taken a big toll on demand for computers and other products that run Microsoft's software, and it's time to settle in for a long slump. There's no recovery on the horizon, Ballmer warned. The economy could remain in the doldrums for "a year, two years—I don't know what it will be—and then start to build back," Ballmer said.

As with other tech bellwethers including Intel (INTC), the "resetting" is hitting Microsoft hard. Second-quarter sales rose a mere 2%, to $16.63 billion, compared with analysts' already-lowered average forecast of $17 billion, according to the earnings report, which was released Jan. 22. Net income fell 11%, to $4.17 billion. And Microsoft said it lacked enough clarity to provide a forecast for the next two quarters. Microsoft's stock tumbled 11.7%, to 17.11, helping fuel a 1.94% decline in the New York Stock Exchange.

So what's a behemoth of a company like Microsoft to do in the midst of so great a downturn? Organic growth is hard to come by for the maker of software running more personal computers than there are cars in operation. And the company's biggest attempt to grow through acquisition, a proposed takeover of Yahoo! (YHOO) in 2008, foundered.

Slimming Down

Instead, Microsoft is slimming down more than ever. "We're significantly putting the brakes on," Ballmer said. In its first-ever broad-based layoff, the company is eliminating about 5,000 jobs, or 5.5% of its 91,000-person workforce. The net reduction will be less than 3,000 because Microsoft will keep hiring in key areas. But the move "shows they are serious about taking at least some initial steps to get their business model more aligned" with the economic conditions, says Technology Business Research analyst Alan Krans. Microsoft also plans to cut travel expenses by 20% and eliminate merit bonuses for the year that begins in August.

Diminished demand for PCs is taking the biggest toll on Microsoft's flagship Windows business, where sales fell 8% to $3.98 billion—far off the company's forecast for 10% to 12% growth three months ago. Executives said sales fell across the board, but especially in price-sensitive emerging markets and among corporate buyers. Many of the PCs that were sold were low-priced netbooks that tend to go for less than $300. For the version of Windows in those machines, Microsoft gets less than half as much as it does for the version in a full-blown PC.

Falling PC sales also hurt sales of the company's Office suite of productivity applications, which includes e-mail and spreadsheet creation tools. That's partly because most netbooks do not have the memory to run it, and because people who use these stripped-down devices do much of their computing on the Web.

Apple's Gain, Microsoft's Loss

Contrast Microsoft's plight with gains by smaller rival Apple (AAPL), which is grabbing market share even though the price premium for Macs over Windows-based machines continues to expand. Ballmer figures Apple gained a point of market share from the year-earlier quarter. Even small gains matter in the mammoth, hypercompetitive PC business. "Apple is gaining share at a remarkable rate," says Needham & Co. analyst Charlie Wolf.

Microsoft's Internet division is losing money at just as remarkable a clip. Losses in the division almost doubled to $471 million from a year earlier. That's on just $866 million in sales. "We need some clarity on their online strategy," says Jeffries & Co. (JEF) analyst Katherine Egbert. "There needs to be some dialogue away from just whether they buy Yahoo or do a deal with Yahoo's search business. Where are they going? What is their strategy?"

Some of Microsoft's businesses are holding up well despite the slowdown. Sales in the division that makes software for server computers, which run Web sites and corporate networks, grew 14%, to $3.7 billion. Many server software sales are associated with multiyear contracts—the same phenomenon that helped IBM (IBM) deliver better-than-expected results on Jan. 20. But even servers won't remain immune "if we stay in this [economic] cycle and we have fewer employed people in the U.S.," Ballmer says.

Another bright spot for Microsoft was its Entertainment & Devices business. The $3.1 billion division posted profit for the second straight quarter, as the company sold 6 million units of its Xbox gaming console—more than double the quarterly sales of Sony's (SNE) PlayStation 3 console, according to Microsoft.

Windows, Clouds, and the Three-Screen Experience

But Microsoft is going to need more than cost cuts and one or two outperforming divisions to deliver any growth amid the recession. Microsoft executives say the company is in the early days of a period of major innovation. The next version of Windows, called Windows 7, is due out next year; an early test version of the software is winning accolades from reviewers. Windows 7 could help power increased sales of low-cost PCs since it is the first upgrade that requires less, rather than more, computing power than previous versions.

And the company recently began rolling out elements of a vast, if somewhat ill-defined, plan to move into so-called cloud computing. At some point in 2009 customers will begin to have the option to run software on their own servers or have Microsoft run it for them via Internet data centers, using a new software technology called Azure.

Also in the offing: Microsoft will upgrade its Windows Mobile software for cell phones. The big-picture plan: to give Windows customers a true "three-screen" experience, where they can easily tap all of their documents, pictures, and other media, whether using a PC, TV, or cell phone. "We'll be having a series of major announcements over the next 18 months," says Andy Lees, senior vice-president for Microsoft's Mobile Communications Business.

Trouble is, Microsoft has been talking about the cloud and about three-screen experiences for years. Now, given the dour outlook for its existing businesses, these new technologies will have to deliver for Microsoft to start outperforming the faltering world economy.

    Before it's here, it's on the Bloomberg Terminal.