The decline of PC sales finally caught up with Microsoft, resulting in weak quarterly results that force Steve Ballmer to propose a radical change of direction

Last week's Monday Note focused on Microsoft's conversion from a divisional to a functional organisation. It resulted in interesting discussions in the comments section as well as in email exchanges and conversations around a couple of Valley watering holes. Some thought Microsoft's statements had the sincerity of a death-bed conversion, others pointed to the challenges in remaking a cricket team into a football squad, most expressed doubts about Microsoft's ability to successfully adapt to a world where the PC no longer reigns supreme.

On Thursday, Microsoft released its numbers for the quarter ending in June, the last of their 2013 fiscal year. They were not good. MSFT lost more than 11% the following day, taking its long-suffering partner HP (-4.5%) with it.

Wall Street's brutal dumping of the stock after "shockingly" bad news isn't surprising, but what should we make of the dogged complacency of the financial seers leading up to the announcement? Did they really not see this coming? Despite a historic five-quarter decline in PC sales, investors hadn't wavered in their belief that Microsoft would find ways to compensate for plummeting Windows + Office profits.

Perhaps I ought to have written cronyism instead of complacency, above. Before the SEC frowned on the excesses of "managed earnings", Microsoft was famous, and comfortable, for always emerging just a penny above its wink-and-nudge guidance. To pull off this funambulist exploit, the company shuffled money in and out of the Unearned Revenue cupboard and other reserves. To paraphrase the old saying, You Didn't Get Fired For Owning Microsoft.

If you think the accusation of cronyism is too strong, take a stroll through the latest earnings call transcript, courtesy of Morningstar, especially the Q&A section. With such an earnings surprise, you'd expect Wall Streeters to inflict company execs with combative questioning and probing follow-ups; you'd look for Steve Ballmer to be front and centre, explaining and hectoring. Instead, we have Amy Hood, the newly appointed (but very experienced) CFO, parrying deferential questions (and very few follow-ups) with mind-numbing answers such as this one:



I think I feel good. I think in some ways the reorg we announced last week along with our increased focus and our single strategy has allowed us to really look and say what are the things we're going to put behind and focus and to improve our execution and so I feel quite good about our ability to do that. And you have heard us say before many of the reasons we did this reorg are about doing things better and more efficiently.

Pity the long-suffering analyst … and if their suffering continues, perhaps we should expect Ballmer himself to show up at the late September analyst indoctrination event in Redmond.

The Microsoft surprise, dubbed by TechCrunch its biggest drop of the century, has infused the discussions of the company's future, what Ballmer will do with his new organisation now that the Redmond Giant (finally!) seems to be aware that it's playing catch up in a post-PC era.

As luck would have it, I got hold of a draft of Ballmer's memo to a small group of Microsoft execs. I can't vouch for its authenticity – it was "regifted" through a series of contacts, friends and foes of old OS wars – but I hope you'll find it interesting:



[Confidential – Burn Before Reading]

From: Steve Ballmer

To: Microsoft Leadership Team - Do not Distribute

Date: July 20, 2013, 6 a.m.

Subject: Windows Mobile 9

It's time for me to confess a serious strategic mistake – and to ask for your commitment to change course and breathe new life into our legacy business.

This is about tablets.

Our own unsuccessful attempts to enter the tablet market (Windows for Pen Computing in 1991, and the Tablet PC in 2002) lured us into thinking there was "no there there". Because of this, we downplayed the impact of a new wave of devices from Apple and Android licensees.

Neither our PR campaign to negate the advent of a post-PC era nor Frank Shaw's valiant efforts to position the new devices as "PC Companions" has had any effect on the market. We even leveraged our long and cosy relationship with IDC and Gartner and got these to firms to create a dismissive category label for these new machines: media-consumption tablets – with the clear implication that they were unsuitable for business uses. All these exertions were for naught. For five consecutive quarters, we've watched PC sales decrease and tablet shipments skyrocket.

This has become a significant threat to the very foundation of our business model.

For more than two decades, the Windows + Office tandem has been a source of incredible power and wealth, it has enhanced the life of more than a billion users and has allowed our company to expand into other high-margin enterprise products and services.

For all these years, we scrupulously followed McKinsey's "not a Single Crack In The Wall" advice, we've managed to successfully Embrace and Extend each and every possible threat to the Windows + Office combo.

While we initially underestimated these new tablets, their threat soon became obvious and we started thinking of ways to protect our franchise.

That's when I took the company in the wrong direction.

To prevent these tablets from penetrating the Office market, I followed our Embrace and Extend strategy and endorsed the creation of hybrid software and hardware: The dual-mode (Desktop and Touch UI) Windows 8 and Surface tablets.

The results are in. Windows 8 hasn't taken the market by storm. The Windows 8 tablets manufactured by our hardware partners are sitting in warehouses. We just took a $900m write-off on our RT tablets, now on fire-sale.

It doesn't matter who actually proposed or implemented the failed strategy, I endorsed it. What matters most – the only thing that matters – is what we're going to do now.

I have a plan. It's conceptually simple but I won't sugarcoat the situation. It will be extremely difficult to execute, particularly given the urgency.

First, I am tasking Terry Myerson, our EVP Operating Systems, with creating Windows Mobile 9, a tablet-capable version of Windows Phone 8 that will serve all of our mobile products. Until last week's reorg, Terry was leading our Windows Phone group and is therefore ideally suited to the new task.

Qi Lu, EVP Applications and Services, will work with Tim to deliver a full, real Windows Mobile Office without the limitations imposed by RT. And, in keeping with our strategic need to spread Office everywhere and to provide the widest base for our on-line Office 365, Qi Lu will also produce Office versions for Android and iOS platforms.

Moving to hardware, we cannot rely on Nokia and other hardware partners to create enough momentum for this new platform, so I've asked our JLG (Julie Larson-Green) to develop first-party mobile devices – a Microsoft smartphone and a Microsoft tablet – that run Windows Mobile 9. The use of the somewhat damaged Surface name for these products will be evaluated as we go.

Everyone else in the company, from Operations to Evangelism, from HR to Finance is expected to give their full support to this most urgent, most vital initiative. In particular, our most recent hire, Mark Penn, EVP Advertising and Strategy, is tasked to come up with the right narrative for the strategic transition to Windows Mobile 9. Earned in unforgiving Washington politics, Mark's long experience with complicated situations will help us navigate the troubled media waters ahead of us.

I know you love this company as much as I do. Thanks for pouring all your energy into this effort.

Steve

I know I didn't fool anyone with this apocryphal memo. While it could be viewed as satirical, it's actually deadly (that's the right word) serious. And it raises serious questions.

First, there's the small matter of implementation. To mangle Brooks's law, nine engineers can't gestate an operating system (or an Office Suite) in one month. Coming up with a "sincere" tablet OS and the corresponding Office version will take time, time during which Android and iOS tablets will continue to cannibalise PCs – and gain hardware and software muscle. This leads to the inevitable question: has Microsoft arrived too late to the tablet feast?

Then there's the question of price and its impact on Microsoft's financials. Software on today's tablets is either free, or priced at a fraction of its desktop PC equivalent. (In retrospect, significantly lower prices for tablet software might have played a role in Microsoft's "safe" decision to stick with a PC/tablet hybrid.) If they go the real tablet route, Ballmer and co will have to tell shareholders to expect lower numbers, even if Office 365 subscriptions partially compensate for the loss in Windows licences and conventional desktop software.

Another thought arises from Ballmer's (actual, not mythical) reference to "first-party devices", meaning smartphones and tablets made by (for) Microsoft and sold by the company, whether through its own stores, its intramural booths at the likes of best buy, or through more conventional retail channels. The math could be attractive: 30% gross margin on a $500 device sure beats 85% on $50 or less of licensing revenue – as long as the hardware unit volume cooperates.

For Microsoft, going for such a business model apostasy, renouncing software licensing for hardware revenue, is easier said than done: an "earnings trough" looms if the old model collapses faster than expected and if the new profit engine takes too much time to come on line. One might bring up the Xbox as an example of Microsoft successfully moving to a vertically integrated business model, but this would be forgetting there was no perilous transition away from juicy operating system licenses, the Xbox was vertically integrated at birth.

The coming months are going to become even more interesting as Microsoft must progress beyond grand statements about its new functional organisation and explain in detail what the new team will actually do.

– JLG@mondaynote.com