The reasons for the drop in sales (and what Microsoft plans to do about it) have been explained in an interview with an executive for Windows Mobile. Talking specifically about where they want to expand the ailing OS, Andy Less elaborated on how they see the software no longer relying on OS upgrades to bring enhancements. He says that one of the primary faults of Windows Mobile was its “lowest common denominator” status, where ensuring compatibility with everybody has come at the expense of greater functionality. That's going to change, of course.
The new strategy involves a more service-oriented phone, one that can more easily integrate with a PC and the Internet. That includes other hardware and software, such as an Xbox and presumably Microsoft's online services. He also mentioned working more closely with hardware manufacturers that make the phones, which could indicate they'll have a narrower profile of phones available. Browser improvements, OS improvements and many other software updates were mentioned, but are definitely no longer their focus. While not admitting that Microsoft is “catching up” to Apple or RIM, most of the changes they have in store seem to be in direct response to their competitors.