Microsoft: How Vulnerable?

It's faltering in court. Its crucial Win2000 system is two years late. And its rivals are ready

Back in its earthbound days, Egghead Software Inc. was a Microsoft Corp. disciple. Not only did it sell hundreds of thousands of copies a year of Microsoft's Windows, Word, and Excel programs in its 150 stores, but Egghead ran its business on the software, too. But last Nov. 21, Egghead left the fold. It completed its move to a cyberspace-only business, taking on the name Inc. At 4:45 a.m., in the company's offices in Vancouver, Wash., a technician switched on the new Web site--one powered not by Windows software but by Sun Microsystems Inc. computers and software. "We held our breath. Fifteen minutes later, we broke out the champagne," says Egghead Chief Technologist Tom Collins.

You can bet the executives at Microsoft were the ones left gulping for air. Egghead had decided that Microsoft's Windows NT software was simply not up to the task of running its Web site. And it couldn't afford to wait around to see if the new industrial-strength version, Windows 2000, would arrive on time. Microsoft has promised Win2000 will ship this year, but buyers are becoming downright skeptical. It is, after all, the biggest commercial software project ever undertaken, with 30 million lines of code--and that figure is growing daily. Now four years under development, Win2000 is an embarrassing two years behind schedule.

By itself, Egghead's defection wouldn't raise an eyebrow. Its business is just a speck in Microsoft's $14.5 billion in revenues. But a loyalist's about-face brings into sharp relief a recent series of setbacks that--don't gasp--could actually slow Microsoft's seemingly unstoppable momentum. Could it be? Will rival software companies actually have, pardon the expression, a window of opportunity? Competitors say this is the moment they've been waiting for. For the first time since the Internet blossomed in 1994, serious threats are surfacing to Microsoft's hegemony. "It's Microsoft vs. mankind, and mankind is winning," quips Sun Chief Executive Scott G. McNealy.

COURT CRUNCH. It would be a moment for the history books. For more than a decade, the software giant has been racking up new customers like billiard balls. It virtually owns the PC software market and in recent years has made inroads pushing Windows past the desktop and into handheld gizmos as well as big corporate computers. Indeed, it has handily aced out rivals for medium-size computing jobs, nabbing 36% of the network operating system market--up from a piddling 6% in 1994.

But suddenly, Microsoft doesn't seem invincible. After looking as if it might ease through the Federal government's antitrust trial with minimal damage, the company is reeling from the latest turn of events. Its defense is off to a disastrous start. Microsoft's first three witnesses failed to explain away internal E-mails that suggest the company sought to use its Windows dominance to harm Netscape Communications Corp., which makes a rival Web browser. And executives botched a technical demonstration and were forced to admit humiliating inaccuracies. If Microsoft loses the case, the remedies could hinder its efforts to make Windows the be-all software for everything from phones to TVs to towering server computers.

Win2000 has its own trials and tribulations. Chairman William H. Gates III calls it the most important product that Microsoft has ever developed. It not only gives the software maker a passport into the so-called glass houses of corporate computing, where mainframes hum away, but also is designed to be the technical foundation for all of Microsoft's future consumer and business software.

RUNNING ON UNIX. Yet it is missing in action at just the wrong time. Today, corporations are rushing to rejigger their businesses to take full advantage of the Internet and are clamoring for ever more powerful servers. But Microsoft's current Windows NT just isn't up to the biggest jobs. Even Microsoft's own 30-million-member HotMail E-mail service still runs on a version of Unix more than a year after Microsoft bought the startup.

Meanwhile, information appliances that allow people to tap into the Web from a kitchen, an office, or even a mountaintop, are catching on fast. From giants Hewlett-Packard Co. and Intel to startups like Aplio, companies are spinning out gee-whiz products that do everything from home banking to heart monitoring. When the dust clears, computing will no longer be the exclusive domain of Windows-based PCs. So far, Microsoft's Windows CE, a slimmed-down version of its PC software, has but 25% of the handheld market.

Rivals are pouncing. 3Com Corp.'s Palm device is flying off the shelves, and this month the company will unveil an even sleeker model that has analysts abuzz. At the same time, America Online Inc. and Yahoo! Inc. are deftly beating Microsoft in the Internet portal wars, while powerful non-Windows computer servers made by Sun and HP are selling fast. Even upstart Linux--the free server operating system that has long captivated the pocket-protector crowd--is suddenly getting attention from corporations. The most amazing part: Microsoft's server market share actually dropped a hair in 1998, after three years of skyrocketing growth.

To be sure, Microsoft's fortunes aren't plummeting. The company just posted a sizzling 38% increase in revenues and a 74% hike in earnings for the quarter ended Dec. 31. But signs of a slowdown in the server arena are unmistakable. Microsoft CFO Gregory Maffei predicted last month that Windows server sales growth will decline this quarter to mid-20%--down from 34% in the preceding quarter--due in part to stiffer competition from Novell Inc. and the Win2000 delay.

Novell is giddy with its newfound success. For a couple of years it had been on the critical list. But Novell beat Microsoft to the punch with the September delivery of its latest network operating software, NetWare 5. And for the first time in two years, it reported double-digit revenue growth in its 1998 fourth fiscal quarter. Says Christopher M. Stone, Novell's senior vice-president for corporate strategy: "There has been so much hype about NT, but people are starting to figure out that the emperor has no clothes."

Or perhaps, the suit is still at the tailor's. Rivals are celebrating, but this shindig may not last long. President Steven A. Ballmer is planning a reorganization that will align product groups with customer segments--so Microsoft delivers the goods buyers really want. He is trying to woo back former Windows czar Brad Silverberg, known for getting products to the finish line. And Ballmer is crafting a new E-commerce initiative. "Microsoft does best when it has competitive threats," says analyst Christopher Galvin of Hambrecht & Quist.

Microsoft's next big growth spurt won't start, however, until Win2000 ships. The company aims to release its third test version on April 21 but won't say when the extravaganza will ship. Analysts predict a truly dependable version won't be out until next year. Sun's McNealy jokingly calls it Microsoft's "W2K problem."

BUGGY TASK. He may have something there. Win2000 has 60% more lines of code than the previous version of Windows NT. Microsoft's engineers have accepted the seemingly impossible mission of creating a program that runs well on everything from a laptop computer to the equivalent of a mainframe. It's like building a car that can compete in the Indy 500 and pull a horse trailer at the same time.

Microsoft admits it has released buggy products in the past and vows it won't issue Windows 2000 before it is 100% ready. Yet some are doubtful. An analysis by BugNet, an online service that tracks problems with software, shows that "every major iteration of Windows has been buggier than the one before," according to BugNet Editor Bruce M. Brown.

This poor track record has caused a wave of ill will in the home computing market, evidenced by proliferating bug sites where users vent frustration. Animosity toward Microsoft also has spilled into the corporate sector, where crashes are measured in dollars and cents. Ask Howard M. Selland, president of Aeroquip Corp., a Maumee (Ohio) supplier of automotive parts. Factoring in lost productivity and bug-busting costs, the bill for upgrading to Windows 95 at his 50-person research lab came to $20,000 a head. "If our products failed as often as Windows 95, we'd have been out of business long ago," says Selland.

GOING FOR DIVERSITY. If Win2000 doesn't break this dismal pattern, it could cripple Microsoft's bid to supply the software for a company's most crucial operations. Corporations are deciding not to lock themselves into any one maker's software. Even at Merrill Lynch & Co., which has a policy of adopting Windows NT aggressively, engineers have designed trading applications so they can be switched from one operating system to another. "We have to be diligent to protect from being overly dependent on any one company," says Vice-President Anthony Pizi.

This time around, Microsoft vows its software quality will be different. "Customers tell me to put up with the massive pressure and don't ship it until we've got it right," says James Allchin, senior vice-president in charge of Windows. When that happens, Win2000 will have a veritable army behind it. The company has enlisted 25,000 resellers. It expects to have 60,000 software applications running on the program. And major software developers such as SAP and Baan Co. are focusing their marketing on it. "Ultimately, the market will go where the applications are, and right now most of the application developers are focused on NT," says analyst Joseph Barkan of the Gartner Group Inc.

That's why competitors have to get their licks in while they can. Sun is Microsoft's fiercest rival. Last fall, it released a major upgrade of its Solaris Unix operating system that offers customers mainframe-level capabilities. Sun also has traction in corporations because of its Java programming language, which is used to write software that runs on any computer, not just Windows-based machines.

The combination has boosted Sun's server sales--now growing at 30%, six times the overall Unix industry growth rate of 5%. Earthlink, an Internet service provider with 1 million subscribers, is one of Sun's converts. Earthlink rejected Windows NT after it estimated that it would take five times as many people to maintain Microsoft servers because things tend to go wrong with them. "Sun has taken great advantage of Microsoft's delays in putting out a true enterprise operating system," admits Bill Larson, CEO of Network Associates Inc., a software company that is closely aligned with Microsoft.

The software giant is used to battling Sun--and wins its share of skirmishes. But Linux could turn out to be Microsoft's Vietnam. The eight-year-old variant of Unix is designed by a guerrilla army of volunteers who distribute it for free. And official versions can be bought for just $50 from companies that sell service and support. Computer executives began taking Linux seriously when it captured 17.2% of the server market last year. "Suddenly, Windows NT isn't the thing that's taking over everything," crows the software's creator, Linus Torvalds. "The tide has shifted."

Linux is still difficult to install, and few stores sell it, so Torvalds' boasting may prove premature. Nevertheless, Linux' list of brawny supporters gets longer each day. Oracle, Netscape, and IBM are rewriting corporate applications to run on it. And PC makers Compaq, Dell, and HP announced they will ship Linux servers. "The Justice Dept. case has helped us a lot with PC makers," says Robert Young, CEO of Linux provider Red Hat Software Inc. "They don't have to worry so much because Microsoft can't be as aggressive as in the past."

BREAKING AWAY. Indeed, some of Microsoft's staunchest allies are beginning to give it fits. Lately, PC makers have shown a surprising streak of independence--especially given that Microsoft is their sole source for Windows. They're reclaiming some of the real estate on the PC's first screen and routing customers to Internet service providers and Web sites of their choice--rather than ones selected by Microsoft. Gateway Inc. even created its own Internet access service, which users activate by clicking an icon on the Windows desktop.

At the same time, computer makers are showing interest in selling machines that don't run Windows. And Linux isn't the only alternative. On Jan. 29, hp, one of Microsoft's closest allies, broke ranks and said it will start selling a so-called database appliance, a single-purpose server that runs an Oracle database and doesn't require a complete operating system. Other specialty server appliances are in the offing as well, including ones for E-mail and security.

While Microsoft is toiling to make a do-it-all operating system, others are betting corporate customers will want simpler devices. Market researcher Dataquest Inc. estimates that more than 2 million non-Microsoft server appliances will be sold in 2002, taking about 20% of the market. "It's becoming an operating system-agnostic world," says Dataquest analyst Kimball Brown.

Even Microsoft's cohort Intel, the other half of the Wintel duopoly, seems to be pulling against its pal these days. Intel, for example, invested in Red Hat, and it also set up a conference on non-Windows server appliances on Jan. 28, inviting such PC makers as Dell and hp. Intel's strategy: to boost anything that will create new demand for microprocessors, no matter what operating system they run on.

In many cases, customers are concluding that Windows is simply not the best operating system for the job. That's partly because corporations are consolidating their data-processing tasks on a few huge central servers--often Unix-based machines--rather than scattering them across hundreds of machines. PaineWebber Inc.'s brokerage business just made the switch. The goal: to cut costs on managing their global network by 66%, according to Senior Vice-President John Furlong. "The pendulum has swung, and it doesn't favor NT," says Morgan Stanley Dean Witter analyst Charles Phillips.

ONLINE WOES. Whom does it favor? IBM, for one. Pundits had written off its "big iron"-type computers, but now they're back in style. Federated Department Stores Inc. relies on IBM mainframes to power its Web site, and IBM is getting surprising interest in its AS/400 midrange computers. Sales of its database for the AS/400 grew 90% last year.

Meanwhile, Microsoft has its hands full in some of the emerging markets. AOL seems unstoppable--boasting 16 million subscribers to its online service, vs. 2 million for Microsoft Network. AOL has proven that it has the Midas touch when it comes to developing the right package of online attractions to lure mass audiences--from chat to community-oriented sites.

Not so Microsoft. Its record as an Internet consumer Web site company is spotty at best. It has invested hundreds of millions of dollars in Microsoft Network and in online properties such as MSNBC, its joint venture with NBC, and has only red ink to show for it. A handful of the projects are hits, including the Expedia travel site and CarPoint auto sales site. But Microsoft's high-profile Sidewalk network of local arts and entertainment sites has been a bust. Its Web-site division has been without a permanent leader for three months, and according to insiders, top outside prospects have spurned the job.

All told, Windows isn't looking like the supermagnet it once was. And unless Microsoft regains momentum quickly with Win2000 and some of its other initiatives, it might see its influence dwindle further--and with it earnings. That's good news for competitors but not investors. They have bid Microsoft's stock up to nearly $400 billion. If Bill Gates stumbles now--in court or in the marketplace--investors will end up being the ones with the real W2K problem in the Y2K.

Before it's here, it's on the Bloomberg Terminal.