Microsoft Slams on the Brakes

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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.

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