The downturn was expected by Microsoft, although the extent of the decline seemed to come as a surprise.
"They knew that consumer [Windows] was going to be tough," said Merv Adrian of Gartner. "It's just very hard to sell an OS these days."
Microsoft blamed the downturn on the consumer side on its decision to give away some Windows licenses and for business, the tough-to-match numbers from 2013, when enterprises scrambled to dump Windows XP, then facing retirement.
Sales revenue from OEMs (original equipment manufacturers) -- the Lenovos, HPs and Dells of the world -- was down 13% both in what Microsoft calls the "Pro" category and the "non-Pro" grouping.
The terms refer to the kind of Windows license, with Pro indicating the OS for business-grade PCs and non-Pro those for consumer PCs and tablets. In Windows 8.1, for instance, the former is Windows 8.1 Pro while the latter is simply Windows 8.1.
Windows OEM licensing was down $455 million from the same period the year before, or about a third of the $1.4 billion total decline for the Devices and Consumer Licensing group, which also includes non-volume sales of Office (consumer purchases of perpetually-licensed Office) and licenses for Windows Phone.
The company's chief financial officer, Amy Hood, acknowledged the Windows revenue downturn, but said it was larger than expected.
"Our results in China and Japan fell short of our expectations," said Hood in a call last week with Wall Street. "In Japan, the PC market lagged due to the macroeconomic environment along with the combined impact of XP end of support and the VAT [value-added tax] increase last year."
The problem with China, added CEO Satya Nadella, was due to "a set of geopolitical issues that we are working through," phrasing that most interpreted as referring to the Chinese government's ongoing antitrust investigation of the American company.
Microsoft's OEM revenue declines were significantly larger than the changes in the personal computer industry, where the Redmond, Wash. company books most of its Windows licensing sales. According to IDC, PC shipments dropped 2% in the fourth quarter of 2014; rival Gartner, which counts systems differently, said shipments grew 1% from the same quarter the year earlier.
On the Pro side, where prices and margins are highest, Microsoft's revenue fell because both the number of PCs sold to business and the percentage of advanced licenses dropped compared to the year prior. "Last year we ended support for Windows XP," said Hood. "That simulated a PC refresh cycle, in particular in developed market and with business customers. As expected, PCs have reverted to a more normal mix between developed and emerging markets, and Pro-attached business PCs [rate] has returned to the levels we saw prior to fiscal year '14."
The reason for the decline in Windows licenses destined for consumer devices was even plainer: Microsoft has been handing out the OS to OEMs for free or nearly so. Since last April, Microsoft has given away Windows to device makers building smartphones or tablets with screens smaller than 9-inches. It followed that with "Windows 8.1 with Bing," a subsidized OS for tablets and notebooks that was either free or came with a minimal price tag.
Microsoft justified the free deals last week.
"Last spring, we made a strategic decision to introduce new Windows pricing programs to drive unit growth in opening price-point PCs as well as tablets," said Nadella.
Microsoft's strategy, dubbed "go low" by Computerworld, is to eschew licensing revenue to boost the pool of Windows users in the lowest-priced bands, including smartphones, tablets and inexpensive laptops. The latter have taken on Chromebooks, cheap notebooks powered by Google's Chrome OS, in the $199 to $249 range. In theory, growing the user base increases developer opportunity -- helping solve the Windows app gap on mobile -- and gives Microsoft a larger pool of people to sell services.
Microsoft has increasingly talked of monetizing Windows through channels other than licensing. Nadella hammered on that again last week, citing larger subscription tallies from Office 365 for consumers and increased revenue from Bing-based advertising and Microsoft's retail chain.
The risk, of course, is that Microsoft won't be able to generate enough revenue from post-purchase services or apps to make up what it loses by giving away or lowering the price of Windows.
"Windows is a big part of their business," said Adrian. "What replaces that"
Answering that question is what drove Microsoft to offer free upgrades to Windows 10, analysts said. Devices running Windows 7 SP1 or Windows 8.1 Update -- the consumer, as well as the "Professional" or "Pro" versions -- will be able to upgrade to Windows 10 free of charge for a year after the new OS's official release.
Microsoft has pinned high hopes on Windows 10 as a primary monetization platform, enough that it wants to move as many customers as quickly as possible to the OS. "The most strategic objective for us is to get developer momentum with Windows 10 and that's where we're focusing," said Nadella.
Windows 10 is Microsoft's best shot, experts agreed. "This needs to happen as quickly as they can move their customers without negative reaction and disruption," said Adrian of Windows 10. "So far, it feels as if they're making the right moves and at the right time."
But not everyone sees roses.
Windows' inherent problem is that it skews to PCs -- Microsoft has an almost meaningless 3% share of the smartphone market and its tablet presence remains in the single digits -- and PCs will be up just 4% this year, according to Gartner.
That means Microsoft would find it harder to drive revenue from device growth, its historical means of monetizing Windows, even if it wasn't leaving hundreds of millions on the table with its giveaways.
"Last quarter's poor performance in Windows sales is much more indicative of the longer-term trend than short-term headwinds. I see Windows 10 slowing the decline a little, but ... I don't see [it] solving any of the fundamental challenges," argued Jan Dawson, chief analyst at Jackdaw Research, in an analysis last week of Microsoft's Q4 2014 financials.
"There are two theories of what's going on with the Windows PC market," Dawson added in an interview. "One is that it's in a slow but permanent decline which may be offset every now and then by things like the XP end-of-life. The other is that there is still growth left in the market, and so the dips are the exception."
Microsoft, said Dawson, believes the latter, while he has taken the former position. "Not just last quarter, but the trend in general is that there is a longer-term decline in store for this market," Dawson said.