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Microsoft's Booster Shots for Broadband

Things just aren't moving fast enough for the folks at Microsoft. In this case, what they're looking to speed up are the connections between people using all sorts of Microsoft products and the Internet. Chairman Bill Gates has even publicly lamented the sorry state of high-speed Net links in the U.S. "Clearly, if you can get [broadband prices] down to $20, $25 a month [in the next 18 months], something then will happen.... But, you know, in the U.S. it's not clear that will happen," he said in April at the Government Leaders' Conference in Seattle.

Now, after talking up and praying for speedy adoption of broadband seemingly for ages and getting no response, Microsoft (MSFT) is trying a more direct approach. It's offering its content to providers of high-speed Internet access to spice up their offerings. The Colossus of Redmond is also building out Xbox Live, an online gaming network with supercool graphics and interactivity, to lure gamers into going broadband. Finally, it's striking more deals with Internet service providers, perhaps in an attempt to help them financially -- essentially subsidizing broadband access for consumers. All told, Microsoft could spend upwards of $3 billion on all these projects in the next two years, according to some estimates.

Will it work? Good thing Microsoft has deep pockets and plenty of determination because a good chunk of Wall Street thinks Gates & Co.'s timing could hardly be worse, given the meltdown in the telecom sector in particular and the overall skittishness of cable and telecom players to invest in this much-hyped technology. Although Microsoft projects that broadband subscriptions will jump by 50% in 2003, fast Web access has failed to excite much consumer enthusiasm so far.

WHO NEEDS IT? In 2000, analysts had predicted that the spread of the high-speed Internet was just around the corner. Instead, the economy took a turn for the worse, and consumers and businesses found broadband too pricey and still unnecessary. Only 20% of about 62 million U.S. households with Internet access will have broadband by yearend, according to tech consultancy Cahners In-Stat. Now most analysts don't expect growth rates for fast Web access to hit the gas pedal until 2005.

Meanwhile, the Redmond (Wash.) software giant's growth has slowed along with the economy. Its revenues will rise only 8% from 2002 to 2003, estimates Mark Specker, an analyst with SoundView Technology. That compares to Microsoft's average annual sales growth of 20% over the past five years. So Specker agrees with Microsoft that faster growth lies in providing bandwidth-thirsty services and applications like movies-on-demand, corporate collaboration, and interactive online games -- all part of Microsoft's vaunted .NET (pronounced dot-net) strategy.

In fact, up to a third of Microsoft's business lines could benefit from faster broadband adoption, estimates Robert Austrian, an analyst with Banc of America Securities. With the ubiquity of high-speed Internet delayed, "it might mean [Microsoft's] growth won't be as fast as everybody hoped," says David Cole, president of entertainment consultancy DFC Intelligence in San Diego, Calif.

HIGHER LOSSES. That's why Microsoft, with revenues of $25.3 billion and profits of $7.3 billion last year, is ramping up its efforts to hasten broadband adoption out of its own pocket. Matt Rosoff, an analyst with consultancy Directions on Microsoft in Kirkland, Wash., believes Microsoft may even be starting to help telecoms cover some of their expenses of providing high-speed service in hopes of getting the lower prices for consumers. As Gates said in his April speech, when broadband prices hit $25 a month, demand could skyrocket.

Microsoft is also increasing the losses it's willing to take to spur sales of its Xbox game console (the only one on the market that comes broadband-ready), hoping that online games will catapult high-speed connections into the mainstream. And on July 11, Microsoft announced a new line of wireless networking products, allowing for fast connections between digital devices within homes (see BW Online, 7/11/02, "Meet Microsoft, Home Networker").

These moves will likely generate billions in red ink up-front, says Speker. This year alone, Microsoft should loose $1 billion on Xbox, estimates Brendan Barnicle, an analyst with Pacific Crest Securities. In May, Microsoft cut the game machine's price from $299 to $199, and today it's selling for $100 to $150 below cost, he says. The company won't start turning a profit on gaming titles and Xbox Live, which it will introduce this year, until 2004, Barnicle says. At that point, online gaming could be among the first .NET services to go into the black.

"LIMITLESS POSSIBILITIES." Microsoft says the eventual payoff overall will be huge. It figures that high-speed connections will turn PCs into always-on centers of home entertainment and communication, making computing more a part of consumers' lives. In turn, sales of Windows XP, online gaming titles, and home-networking products would get a major boost, putting Microsoft back on the double-digit growth track. "It's really the way the Internet goes from being a daily struggle, with dial-up, to a consumer-like experience," says David Hufford, Xbox marketing manager. "The possibilities with broadband are limitless."

Dream on, say many analysts. Even Microsoft, with its deep pockets ($5.1 billion in cash and cash equivalents as of Mar. 31), can't lower the tide of trouble now washing over broadband ISPs. Telecoms, ranging from WorldCom (WCOME) -- which filed for bankruptcy July 21 -- to Qwest (Q) are in financial distress and, for at least the next year, will be busy trying to avoid sinking further.

They're unlikely to lower their prices on broadband or expand their networks to encompass more homes, both crucial moves in speeding up broadband adoption. Today, digital subscriber line (DSL) connections typically cost $49.99 a month for consumers, vs. about $14.99 for dial-up connections. Worse, DSL is available only in limited areas.

TROUBLED PARTNERS. Telecom woes could clearly hamper Microsoft's efforts. Take local-phone company Qwest. Under an April, 2001, agreement with Microsoft, Qwest (in which Microsoft holds a 1.33% stake), exclusively markets MSN Internet access to its dial-up and broadband subscribers in 14 states. Under the agreement, Qwest customers who sign up for broadband receive MSN content by default and use a customized Qwest-Microsoft co-branded Web browser. The deal was struck after Microsoft's earlier partner, NorthPoint Communications, went bankrupt.

Today, however, Qwest is in trouble, too. Its credit rating had been downgraded to junk. The Securities & Exchange Commission is investigating its accounting practices. And on July 11, the U.S. government's General Services Administration launched a review of Qwest's federal contracts. Still, "the relationship with Microsoft is going smoothly," says Asilvia McLachlan, a Qwest spokesperson, who declined to provide any other comments.

However, Microsoft is already reacting to the shifting telecom landscape. On June 20, it struck a similar pact with the nation's largest phone company, Verizon (VZ). The software giant is trying to build its ties to the industry's stronger players, says David Readerman, an analyst with Thomas Weisel Partners.

FIRST STEP TO .NET? Few details about the Verizon pact were disclosed, but starting in early 2003, any customer signing up for DSL with Verizon would get MSN content and services through a default customized browser, explains Paul Symczak, Verizon Online's director of business development. Although some users could elect to change their default homepage, Microsoft expects most to stick with MSN, allowing Microsoft to later market its various .NET services directly to them. Symczak says either Verizon or Microsoft will handle billing and service, depending on which one signs up the customer.

Microsoft is likely also in talks with cable companies (it already has a broadband deal with Charter Communications) as well as Baby Bells SBC Communications (SBC) and BellSouth (BLST), says analyst Rosoff.

For the ISPs, such an agreement with Microsoft could be a sweet deal. MSN content will allow Verizon to differentiate its services from competition, says Verizon Online's Symczak. Plus, Rosoff believes that Microsoft is helping its partners financially, though neither Microsoft or Verizon are saying what the terms of the deal are. That help should, in theory, translate into Gates's much-wish-for lower broadband prices for consumers.

BROADBAND-CRAZY KOREA. Still, Microsoft might be a bit late to the game with some ISPs. Baby Bell SBC, for one, says it won't comment on speculation about possible deals. But late last year, the telecom struck a deal to offer Internet services with Yahoo! (YHOO). The companies' co-branded DSL service will be rolled out in the fall, says SBC spokesperson Selim Bingol.

Meanwhile, Microsoft's efforts in online gaming might not come to fruition anytime soon, either. Although online game StarCraft, from Irvine (Calif.)-based Blizzard Entertainment, did wonders to hasten high-speed Internet adoption in South Korea, according to Nielsen/Net Ratings, other countries are proving different. As of last December, 15% of South Koreans, or 7 million homes, had broadband connections. That's about as many homes as in the U.S., with a population of 287 million.

Microsoft's Xbox Live gaming network will debut as a $49.95-a-year service, requiring players to have Xbox consoles as well as broadband subscriptions. DFC Intelligence's Cole says it likely won't be a big draw right away since Microsoft will need time to work out the bugs and build up the all-important buzz. Only hundreds of thousands -- not millions -- of users will use Xbox Live by yearend 2003, he estimates. After all, only 33% of Xbox's 2 million U.S. users now subscribe to broadband, says Cole.

BETTER THAN AOL? "We wish them all the luck," says Jim Merrick, director of network marketing for rival gaming company Nintendo (NTDOF.PK

and NTDOY.PK). Nintendo has no plans for a special online gaming network, though it will offer an add-on broadband adapter for its consoles in the fall, he says. "The mass market is [still] the dial-up," Merrick explains.

That's certainly not what Microsoft thinks. "Many new consumers will sign up for Internet access in the next year, and many existing dial-up users will switch from their current ISP to a broadband provider," says Lisa Gurry, MSN product manager.

Another challenge for Microsoft is to make sure its move into broadband goes better than that of online rival America Online (AOL) (see BW Online, 1/4/02, "How Broadband Could Slow Down AOL"). Only a few hundred thousand existing users were paying for AOL Broadband as of January, the most recent available data. And, according to Buckingham Research Group analyst Ken Kiarash, overall growth rates of Microsoft's user base are now higher than those of AOL, partly because of Microsoft's broadband offerings.

Still, if AOL -- which has the seeming advantage of Time Warner Cable's 13 million subscribers -- is having trouble spurring folks to go high-speed, Microsoft might have to spend more -- and stick with the strategy longer -- than it expects. By Olga Kharif in Portland, Ore.

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