One by one, companies have started announcing earnings in which the full pain of the current economic crisis has hit their bottom line. Microsoft was no exception; while revenue increased slightly year-over-year, earnings dropped slightly. The company has a tradition of hosting an additional financial call in which it looks forward to the second half of its fiscal year and discusses long-term plans. The latest version of that call took place Tuesday morning, hosted by Steve Ballmer and CFO Chris Liddell, who gave a much clearer picture about the company's view of these turbulent economic times.

The call clearly suggested more grim news was on its way. Liddell described how the finances held steady through the fiscal first quarter, and only started to decline during the second, with the later portion of the second quarter being significantly worse than the first. That decline shows no sign of abating, as Liddell said, "we expect conditions to remain similar throughout the second half." More generally, Ballmer suggested that Microsoft's general take on things is that the current crisis represents a "major deleveraging" event and, historically, the economy tends to take a long time to reset to a new level after these events; growth doesn't start again until that reset takes place. This is a bit more pessimistic than some economists, but gives a sense of the company's bunker mentality.

To help ride out the storm, Microsoft is planning to reduce expenses, primarily through cuts that total a bit over $2 billion in the second half of the year; beyond that, plans are to keep expenses flat for fiscal 2010. But it was very clear that Microsoft wasn't simply going to keep cutting until it had satisfied analysts. "It's not like anybody's able to cut costs fast enough—in any industry—to retain the profits of yesteryear," Ballmer said, and he repeatedly emphasized that R&D spending was essential to its plans to compete in a number of markets that Microsoft considered too important to give up on. There were also a number of expenses that the company would surely like to avoid, but generally couldn't. "Our legal budget," Ballmer said, "is likely to be larger than the legal budget of the average company of our size."

Core businesses

Ballmer mentioned Apple's rise in market share, saying it was too large to ignore, but not as big as press reports might suggest. When it comes to market share, the second-biggest competitor remains pirated Windows, which also has the advantage of being free.

Ballmer went through each of the areas that the company views as major business focuses. For the most part, the traditional Microsoft businesses are doing well. Client software remains very profitable, although it is taking a bit of a hit. Consumer spending is shifting to netbooks, and it is very clear that Microsoft is getting far fewer profits from the version of XP it has prepared for these devices. Ballmer emphasized that he feels that Microsoft can compete with Linux on features in this device category, and plans on having a version of Windows 7 that will do so, but it's clear that the competition with a free alternative is hurting, and the pain may get worse, as the company fully expects that Android-based netbooks are an inevitability.

Ballmer mentioned Apple's rise in market share, saying it was too large to ignore, but not as big as press reports might suggest. When it comes to market share, the second-biggest competitor remains pirated Windows, which also has the advantage of being free. Piracy is an even bigger problem with productivity applications like Office, where the other competition, such as OpenOffice, remains even weaker than the OS competitors. In the consumer space, Microsoft has dropped prices and seen the increased sales offset the profit decline, and it appears willing to tolerate poor profits from educational pricing indefinitely. Ballmer confirmed that Office 14 won't be arriving this year, so his market will have to coast a bit going forward.

In the Enterprise, the company has been able to avoid dropping prices by offering integration with its other enterprise products, and upselling it as part of a larger package of services. Enterprise sales in general, while seeing declines, have held up better due to the long-term contracting, which Liddell termed "annuity sales." This is especially true for server and tools, where two-thirds of the sales fall in the annuity category.

The big competition for servers remains Linux, which is dominating Web serving and scientific computing (Windows dominates in business application and infrastructure workloads). Price clearly remains the sticking point here, and Ballmer announced that there will be a Windows "Foundation Edition" Server released this year, which will sell on the low-end servers that he called "akin to netbooks." He also acknowledged the difficulty of competing with Oracle, which is outspending Microsoft both in terms of R&D and marketing. The big hope there is in new "datacenter" and Azure/cloud versions of SQL Server; elsewhere, Ballmer noted that corporate migrations to cloud services were going well so far, although the move happens slowly.

Browsers, smartphones, and search

Ballmer highlighted the browser market in red, as it's one area where the company is seeing significant market share losses—he unironically termed browsers "key features of operating systems" at the same time he emphasized that Firefox is the primary cause of IE's decline. IE8 was touted as the big hope for reversing that, but it's not clear what reality that optimism is derived from. The IE team is struggling with compatibility issues while its competitors push to meet new Web standards.

Ballmer recognized that, in the consumer space, the momentum lies with Apple, but said it's with Windows Mobile and Android outside of that space. He then went on to explain why everyone other than Microsoft had it wrong.

Windows Mobile fell into the "somewhat unprofitable" category, but the attention lavished on it suggests that Microsoft has awakened to its strategic importance. The company is apparently hoping that it will be able to leverage some of the desktop OS development to increase its slow pace of development. Ballmer said, "the amount of technology that can be shared across that border continues to go up," and he combined the R&D budgets of the two groups in an attempt to show how well it stacked up against competitors like RIM.

Ballmer recognized that, in the consumer space, the momentum lies with Apple, but said it's with Windows Mobile and Android outside of that space. He then went on to explain why everyone other than Microsoft had it wrong. Referring to Android, he said, "I don't know how it is a sustainable thing to not have a positive price," and he argued that he expects the Windows Mobile model, in which hardware and software is divorced, to win out in the end. The key message here is that you shouldn't expect Microsoft to be making its own phone, which Ballmer said, "is not our strategy."

Of course, similar things were once said about portable music players, and yet we have the Zune. That's apparently different, because it's part of a tool for a larger entertainment strategy. Ballmer promised that the Zune entertainment services would be coming to all three screens: the PC, the TV, and portable devices. The Xbox is simply another cog in this strategy, as Microsoft is looking to develop a "dollars per TV" revenue strategy—"the real opportunity is a device that sits next to or in a TV set," said Ballmer. The precise device involved is apparently far less relevant than the fact that Microsoft is on the end of the revenue stream. It's an interesting take, and one that the company may now have the pieces in place to attempt, but, without some well-enunciated roadmap to get there from here, it has a bit of the feel of a post-hoc rationalization.

Ballmer made a more compelling case when discussion arose about another market the company has struggled in, search advertising. He argued that search is the key advertising business and portal properties could, at best, support the growth of a search property. He also described how search and the ads run with it were mutually reinforcing: consumers, consciously or not, rate the credibility of the search results in part by evaluating the relevance of the ads that appear with it.

But if Microsoft had a more compelling case for the importance of search, it didn't have a clearer roadmap on competing in that market. Ballmer is still interested in combining with Yahoo to take on Google, and isn't picky about how it gets there. But, beyond that, it appears focused on new product releases, something that the consumer population doesn't seem to really register.

This mixed strategic vision—Microsoft has identified some key markets for growth, but doesn't seem to have a concrete plan for actually growing in them—is probably more worrisome than the grim financial news. Microsoft is likely to be taking a bigger hit as the fiscal year continues to be dominated by bad news, but it probably won't be as bad as the hits that many other companies have taken, and Redmond appears well positioned to continue to excel in the markets it already dominates when the economy recovers. But, in Apple, Google, and RIM, it's facing competitors that appear to have a clearer picture of what needs to be accomplished in these other markets. In cases like the TV set-top, where there really isn't competition, Microsoft doesn't appear to have an equivalent picture. If there's something in the works behind the scenes, this press call didn't lift the curtain on it.

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