Microsoft's Downbeat Outlook

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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.

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