Six years ago, Microsoft (MSFT) and America Online (AOL) cut a deal that will go down as one of the savviest ever. Microsoft Chairman William H. Gates III agreed to put the Internet service provider's icon on the desktop of its Windows software. The easy access for consumers helped generate nearly 30 million subscribers for AOL's online community and propelled it to the top of the Web heap. In turn, AOL then-CEO Stephen M. Case agreed to make Microsoft's Internet Explorer its default Web browser, ultimately helping to give it millions of browser users.
Now, in contentious negotiations over bundling AOL into Windows XP, the next generation software due out on Oct. 25, Microsoft and AOL are playing a game with even more at stake. Each company is currently jockeying to be the dominant player in the next generation of the Net, when consumers are expected to shell out billions on such services as access to new music and online game playing. The outcome of the talks could play a big role in whether Microsoft can successfully maneuver to displace AOL as the king of the consumer Web--or whether AOL can contain Microsoft. "The ultimate goal for both companies is to own the living room in the U.S. and eventually take that to the world," says Rob Lancaster, an Internet analyst at Yankee Group Research Inc.
WHO NEEDS IT? Thing is, whatever hand Microsoft plays, AOL has better cards. Sure, computer makers will sell nearly 160 million Windows-loaded PCs next year. That's a big reason why AOL is again negotiating to get its icon front-and-center in the new Windows. But AOL can do that without Microsoft. In recent years, it has cut deals with the biggest computer makers. It costs AOL money, but many now put its icon right on the PC desktop.
What's more, Microsoft needs AOL more than AOL needs it. A year ago, Microsoft laid out a sweeping new Net strategy dubbed .Net. It promises to let unrelated Web sites talk to one another--and to other programs on a consumer's PC. For example, .Net would allow a user to purchase stock, transfer funds for the purchase, and update his personal-finance software with just one click.
But to succeed with .Net, Microsoft needs consumers to give it a try. That's why AOL is so crucial. While its MSN Internet Access service has doubled to 5 million--making it the No. 2 service behind AOL--AOL's 30 million consumers are a far juicier prize. If Microsoft can convince AOL to let users of its own instant messenger service talk with AOL's as part of the Windows XP deal, for example, it could help the software giant get AOL's customers to try .Net.
Of course, AOL risks losing customers in the process. That's why it's holding onto its doozy of a trump card--the threat to pursue further legal action against the software giant for antitrust. Microsoft is clearly loading Windows XP with all sorts of new features aimed directly at AOL. For example, on June 4, it announced a service built right into its operating system that offers text messaging, voice conversations, video conferencing and document sharing. AOL's take? That Gates & Co. are still using Microsoft's Windows monopoly to leverage into applications markets.
Microsoft is pushing AOL to agree not to sue over such new disputes. AOL could also still bring a private antitrust suit over earlier claims involving Netscape. But AOL is balking. "It makes no common sense, no business sense, no legal sense, and has no precedent for us to give them a get-out-of-jail-free card," says AOL Executive Vice-President Kenneth B. Lerer. AOL clearly recognizes Microsoft is aiming for the very heart of its business. If it isn't careful, a wily Microsoft may play its way to the biggest jackpot yet. By Jay Greene
With Amy Borrus, who covers America Online in Washington