Microsoft: How It Became Stronger Than Ever

The software Goliath has an arsenal of new monster products. Will the courts slow it down?

When 20,000 Microsofties streamed into Seattle's Safeco Field last September for the annual employee meeting, CEO Steven A. Ballmer knew he had to fire up the troops. It had been a stinker year for the software giant. Microsoft Corp.'s (MSFT ) revenue growth had slowed to 8% from an average annual rate of 36% through the 1990s, a federal judge had ordered the company snapped in two for violating antitrust laws, and $250 billion had evaporated from Microsoft's market value. Worst of all, with the Internet moving to the center of computing, PC pioneer Microsoft seemed on the edge of irrelevance.

So Ballmer dipped deep into his bag of motivational tricks. On a huge video screen, he played a clip from a documentary about the epic 1974 title fight between Muhammad Ali and George Foreman. Foreman, seven years younger, was expected to win. But Ali was the people's choice, and the 60,000 fans in Zaire that night broke into spontaneous chants: "Ali, bomaye! Ali, bomaye!" meaning "Ali, kill him!" Ali leaned back against the ropes and absorbed blows from Foreman on his gloves and his forearms but gradually wore him out. Finally, Ali pounced, sending Foreman to the canvas. As the video ended, the loudspeakers resounded with a new chant: "Microsoft, bomaye! Microsoft, bomaye!"

Like Ali, Microsoft had absorbed some bruising body blows in its own Rumble in the Jungle, Ballmer told the crowd. "We were getting shots from everywhere. Maybe we even had a little fear in our eyes." Then his voice suddenly rose to a shout: "You know what I say? I say we're off the ropes!" The Microsofties roared.

Back then, Ballmer's rallying cry was mostly wishful thinking. Now it's starting to look like an understatement. Not only do Microsoft's over-the-hill days seem over, but it is emerging more powerful than ever. Instead of the Internet relegating Microsoft to the sidelines, the software maker has grown stronger in its core PC business, gained ground in the lucrative enterprise corporate market, and fought its way very nearly to the top of the Internet heap.

All the while, it has been making mind-boggling amounts of money. While competitors are pinching pennies in this harsher economic environment, Microsoft is awash in cash: $30 billion, more than any other company in Corporate America. Moreover, it's adding $1 billion a month to its bank account, thanks to its Windows and Office monopolies. That gives it the luxury to invest in other companies and spend lavishly on new business ventures while stoking its product pipeline--all crucial for extending its dominance. This year, Microsoft will spend $4.2 billion on research and development, more than rivals America Online (AOL ), Sun Microsystems (SUNW ), and Oracle (ORCL ) combined.

Now, Microsoft is about to unleash the biggest onslaught of new products in its 25-year history. It starts on May 31 with the launch of Office XP, the latest version of its word processing and spreadsheet program that accounts for roughly a third of the company's revenue. Next up, Stinger, a new operating system for cell phones, followed by Xbox, Microsoft's bold leap into the game-console business. And on Oct. 25 comes the big kahuna: Windows XP, a potent new version of its desktop operating system that Chairman William H. Gates III says is Microsoft's most important product since Windows 95. "We've never had a year with this many new products," he crows.

Windows XP is far more than just another spiffy rev of Windows software. With XP, Microsoft can finally harness its battery of products and Web sites, feeding customers from one product into another in a chain reaction with a potentially explosive result. Test versions of Windows XP include quick access to an easy-to-use browser that has a button that starts Microsoft's Windows Media Player. That browser zips you to Microsoft's MSN Web portal, which then offers simple ways to sign up for its instant-messaging and Internet mail service. What's more, Windows XP offers to plug you in to altogether new Internet services, such as Microsoft's alert system that e-mails or pages you when a flight is late or a stock dips low enough to buy.

HOOKS EVERYWHERE. Add it up, and Microsoft's ability to elbow aside rivals is staggering. Start with Windows. Analysts expect computer makers to sell 160 million PCs running Windows next year. On the Web, its MSN Internet-access service has 5 million subscribers. More than 50 million surfers hit its MSN portal each month. Its free e-mail service just landed its 100-millionth account. And its instant-messaging software is approaching 30 million users. Each product will feed on another. Its instant-messaging service will encourage users to sign up for Microsoft's Hotmail. Netizens who land on the MSN portal will be hawked to the access service. And Windows will push users to each piece of the empire. These hooks from one product to the next have rivals in a tizzy. "The threat that Microsoft poses is to turn the Internet into a company town--a Microsoft town," says Jonathan Schwartz, senior vice-president of corporate strategy and planning at Sun Microsystems Inc.

Nonsense, says Gates, the Web is too vast for one company to rule. He insists that the way he's handling Windows doesn't stifle innovation by others. "There's no block to people putting features on Windows," he snaps. Indeed, there are dozens of markets where Microsoft doesn't play, such as online stock trading and e-tailing. And Microsoft has had its share of busts. Remember its Sidewalk hometown portals?

Instead, he sees the intertwining of Microsoft's products as a way to make the Internet a richer experience. His latest offerings bring Microsoft closer to the grand vision he has spun since he awoke to the Web six years ago. Gates sees a day when Microsoft software will run on any device, easily connecting people to the Internet wherever they happen to be. He's convinced that the way to achieve this "anytime, anywhere" computing is by weaving Microsoft's PC, server, set-top box, cell-phone, and handheld programs in with its Internet service technologies. Once that happens, Microsoft hopes to deliver software like a steady flow of electricity, collecting monthly or annual usage fees that will give it a lush, predictable revenue stream. "This era is one where we are certainly out front," says Gates, rocking in his chair with trademark intensity.

HOME FREE? If everything works as planned, Microsoft's software could be at nearly every point a consumer or corporation touches the Web. Since the Internet is now the backbone of most computing, that puts Microsoft at the center of all things digital. It's a huge turnabout for a company that was mocked for being late to the Net. "We're not playing catch-up," Gates says. "We're back in a pioneering position."

And, soon, Microsoft might not have a breakup order hanging over its head. The D.C. Circuit Court of Appeals is expected to rule any day now on the company's appeal. Based upon the questions asked at oral arguments, most legal experts believe the court will reverse at least one of Judge Thomas P. Jackson's findings: that the company illegally "tied" a browser into its operating system, that it acted illegally to defend its Windows monopoly, and that it attempted to divide the browser market with Netscape Communications Corp. If any part is thrown out, it's unlikely the breakup order will be sustained. Instead, the appeals court would probably send the case back to a lower court to determine remedies, which could trigger settlement talks. If the lower-court ruling is overturned, Microsoft is home free, pending an appeal to the U.S. Supreme Court by the state attorneys general who brought the suit along with the Justice Dept.

To competitors, there is no worse nightmare. It's as if the appeals court is about to unleash a hungry rottweiler in a steakhouse. In an effort to keep the collar cinched, rival AOL Time Warner Inc. has launched a clandestine lobbying campaign, warning Senate staffers about new threats to competitors and consumers. A presentation prepared for the meetings that was obtained by BusinessWeek calls Microsoft's Internet strategy "the boldest, most aggressive move in Microsoft's history to leverage their [Windows] monopoly to create a bottleneck that will constrict the Internet." Says AOL Executive Vice-President Kenneth B. Lerer: "It appears they're doing all over again what they did when they previously went into foul territory." Sun Microsystems CEO Scott G. McNealy says letting Microsoft off the hook will stifle innovation. "We'll have to live with the consequences," he warns.

Already, many of the innovative Web software upstarts are in a mess, but of their own making. The Internet revolution promised a world where thousands of companies would flourish and the Web--not Microsoft---would be king, since it is built with industry-standard technology that everyone can use. The theory was that even while the antitrust case dragged on, market forces would keep Microsoft in restraints. But with the collapse of Net stock prices, the venture-capital well running dry, and not enough profits in the upstart's coffers, these would-be revolutionaries are hard-pressed to continue their fight. More than 400 Net companies have gone out of business in the past year. Many of those that remain have seen their stock prices sink by 90% or more.

"THEIR VIETNAM." Microsoft is a study in the opposite. Even with the Nasdaq off 9%, its stock price has soared 60% this year, to 70, outperforming the rest of the Dow Jones industrials. The company bested analysts' expectations for the quarter that ended Mar. 31, earning $2.45 billion on sales of $6.46 billion. That led influential Goldman, Sachs & Co. analyst Rick Sherlund to add it back to his recommended list. "Microsoft has been playing defense for the last six years," says Sherlund. Its Internet technology "is all about turning the tide and going on the offense." Sherlund expects Microsoft to post revenue growth approaching 20% within a couple of years.

You can feel the old feistiness on the sprawling campus in Redmond, Wash. During the antitrust trial, Microsoft became an industry pariah, with only its most loyal partners coming to its defense. Burnt out or lured by the Net, about 20 top managers left, including Chief Financial Officer Greg Maffei and Paul Maritz, the architect of the new Net strategy. Microsoft often lost out on recruiting the brightest college grads. "It was their Vietnam," says Roger S. Siboni, CEO of software maker E.piphany Inc. (EPNY ) Now, the departures have slowed to a trickle. And Microsoft says that 86% of candidates offered jobs accept, vs. 79% during the dot-com craze. While industry stalwarts such as Cisco Systems (CSCO ), Yahoo! (YHOO ), and Dell Computer (DELL ) are laying off workers, Microsoft expects to hire 8,000 people in this fiscal year.

Still, the heavy lifting has only just begun. Much of Microsoft's success will depend on its ambitious Internet strategy dubbed .Net. This year, Microsoft will spend $2 billion on .Net technology that will make it possible for unrelated Web sites to talk with one another and to programs on a PC. One click can trigger a cascade of actions without requiring the user to open new programs or visit other sites. The strategy relies on Microsoft persuading software programmers to use the technology, yet many tech companies still harbor a deep distrust of the company. At the same time, Windows 2000, its operating system for powerful server computers, has only begun to convince corporations that it's ready to handle the most demanding jobs. And to succeed as a Web services company, Microsoft will have to get consumers to pay, while most experiences on the Web are free. Fierce competitors await: AOL in the Internet market. Sun Microsystems in servers. Oracle Corp. in heavy-duty corporate software. And IBM everywhere.

The new Microsoft is once again like the old Microsoft: undaunted. "We want to keep the pedal to the metal," says Ballmer. Indeed, Microsoft seems more aggressive than ever. Windows XP is where its bundling strategy notches up a level. In test versions, when consumers start up a PC equipped with Windows XP for the first time, they'll see a host of changes making Microsoft products available with one or two clicks of a mouse. Consider the Passport service. Windows XP prompts consumers to sign up the first time they log on to the Web. If they agree, they'll be asked a series of questions about where they live, their e-mail address, and their credit-card numbers. Rather than fill out a new form every time a Web surfer visits a site or submit a password on sites requiring it, Passport transmits the information directly, saving time and hassles.

Sounds pro-consumer. But Microsoft's enemies are portraying Passport as the Trojan Horse that could allow the company to dominate much of the Internet. Because of the software maker's incredible distribution power, opponents fear that Microsoft will be able to turn it into the ubiquitous payment and identity-authentication system on the Net. Microsoft already boasts 160 million Passport accounts. Although many of those are duplicates, this base of customers will only get bigger, since 160 million new Windows PCs are expected to be sold next year. As sales grow, it will be easier for the company to convince Web-site owners that they ought to accept Passport. That, in turn, will trigger more consumers to sign up--the type of powerful cycle that winds up creating monopolies. That puts Microsoft in the position, if it wants, to charge online merchants a fee for its Passport service. Although the company now denies that's the plan, its executives in the past talked about collecting fees for every e-commerce transaction.

Microsoft executives bristle at talk of Trojan Horses and the suggestion that bundling its Net services into Windows is unfair. "We have behaved consistently," says Ballmer. "We believe the law entitles us and encourages us to continue to innovate and add new capability. We thought that five years ago, two years ago, one year ago, now. We have not varied in our craft. We haven't stopped adding things to Windows."

Once you're a Passport member, you're set up to subscribe to a new set of services called Hailstorm. These include everything from notifying users of specific events to automatically updating their calendars when they purchase tickets or make an appointment online. Already, a half-dozen corporations have signed up, including No. 1 Internet auctioneer eBay Inc., which is building a service that instantly notifies customers when their bid has been trumped.

"ALL THE PIECES." Other companies are expected to engineer similar technologies for linking Web sites, but Microsoft has tremendous advantages. It can mobilize the army of 5.5 million Windows developers. It has an array of now-mature server software handling everything from e-commerce to databases. And it has Windows. "Microsoft has all the pieces to make this thing go, and no one else does," says analyst Ted Schadler of Forrester Research Inc.

Hailstorm is the next step in Microsoft's monumental switch from selling software programs to offering a vast array of services over the Web. Gates and Ballmer foresee a time when most of their revenues will come from subscriptions. In addition to Web services, Microsoft is retooling its software programs so they, too, can be rented out via the Net. Consumers will be able to buy a basic package of services: word processing, say, for a few dollars a month. Or they could shell out $20 for a package that includes word processing, scheduling, and e-mail services, along with online storage to keep music collections and photos.

There's still a lot of packaged software to be sold, especially to corporations. Microsoft is just now becoming a major player in the upper reaches of corporate computing. For much of the past decade, Microsoft unsuccessfully tried to run the technical plumbing of huge organizations--the industrial-strength servers that kept corporate networks humming and handled their most important transactions. Windows 2000 Datacenter Server, released late last year, began to change all that. Now, J.P. Morgan Chase & Co. (JPM ) is running its commercial-loan processing system on Windows server software, and the electronic stock-trading network, Archipelago, handles 100 trades per second using Windows and Microsoft's database software. The market for Windows servers grew 32% last year, to $13.9 billion, while sales of servers running rival Unix grew only 14%, to $29 billion. The software impresses even former naysayers. "The giant is back," says Gary Bloom, the former No. 2 at Microsoft archrival Oracle who is now CEO of storage software company Veritas Inc. (VRTS )

The key to winning more corporate business will be .Net. Microsoft aims to provide the technology that will turn Web sites and software programs into virtual Lego pieces. If it comes together as planned, companies will be able to snap sales, accounting, and inventory software programs together so that customer orders automatically update balance sheets and set off requests to replenish supplies. Today, each of those steps is handled separately. Microsoft is betting that customers will pony up for its server software and tools to build their own creations.

One of its first converts is Matthew W. Dunn, the chief information officer at Intrawest Corp. (IDR ), a Vancouver (B.C.)-based skiing operator with 10 resorts, including Whistler Mountain in British Columbia and Copper Mountain in Colorado. He wanted to set up a single Web site where skiers could book vacations to any of its resorts, arranging for lodging, lift tickets, ski rentals, and classes. But Dunn also wanted to tie those orders back into Intrawest's software programs that track customer relationships and accounting.

SLIPPERY SLOPE. It proved tricky. He ran into glitches with software from Oracle and e-commerce software maker BroadVision Inc. (BVSN ) But using early versions of Microsoft's .Net technology and e-business software from Vancouver-based Pivotal Corp. (PVTL ), he got the system running in just 90 days. Intrawest booked about $1.5 million worth of business online last winter, even though about half of its destinations weren't tied into the new system for most of the season. With those properties available next season, Dunn expects the Intrawest site to generate $10 million. Equally important, Intrawest is creating a customer database that tracks everything from the kind of lodging visitors like to resorts they have visited. With this data, it can offer customers special deals they're likely to find appealing.

With Microsoft's girth and need to grow quickly, there's hardly a sizable market it can ignore. Next up: programs for small and medium-size businesses. For years, Microsoft left that market to others, content that the accounting, human-resources, and procurement applications would run on top of Windows. Microsoft jumped in headfirst last December when it agreed to acquire Great Plains Software Inc. for $1.1 billion. The Fargo (N.D.) company is a leader in finance and accounting software for smaller businesses. But accounting is just the first step for Microsoft. "It's good but not that interesting," says Jeffrey S. Raikes, group vice-president of the productivity and business services division. "Steve [Ballmer] is telling me to build the multibillion-dollar business."

So Microsoft is cobbling together an entire suite of business applications that handles everything from accounting to customers to procurement. What it doesn't build, it will buy, or it will partner with other software makers to fill in the gaps. This "suite" approach is how Microsoft conquered the market for desktop applications. Ultimately, Microsoft plans to plug these applications into bCentral, its small-business Web site, and offer the software as services. According to AMR Research, small and medium-size companies spent $19.3 billion on software last year. "It's quite compelling and quite frightening, I'm sure, in some quarters," says analyst Dwight Davis of Summit Strategies.

Who should be scared? London-based Sage Group (SGGRY ), for one. The niche software maker went mano a mano with Great Plains, a company its size, and did quite well. Now it faces a giant with the deepest pockets in tech. "Are they a gorilla? Absolutely," says Sage CEO Paul Walker. He has confidence, though, in the ability of Sage's products to succeed. But that's what the execs at WordPerfect and Lotus thought when Microsoft set its sights on the word processing and spreadsheet markets.

Microsoft is tapping its war chest to attack new consumer markets, too. Take Xbox, the $299 game console that Microsoft plans to launch on Nov. 8. Microsoft will spend tens of millions developing the box. And it plans to spend $500 million more marketing it over the next 18 months, competing with Sony Corp.'s (SNE ) $299 PlayStation 2 and Nintendo Co.'s (NTDOY ) $199 Gamecube. Merrill Lynch estimates that Microsoft will lose $800 million on Xbox in the next fiscal year. But with a $20 billion market in its sights and with competing game consoles adding Web browsing and e-mail, Microsoft is running a marathon, not a sprint. "When we see a strategic need, we're very persistent, we're very committed," says Xbox boss Robert J. Bach.

They'd better be. Although Xbox will deliver more than three times the processing speed of other consoles, it has a long way to go to match the competition's hit games. Nintendo's Pokemon and PlayStation's Crash Bandicoot drive console sales. "Microsoft is an amazing company and Bill Gates is a great leader. But the people at Microsoft are human, and that means there are things they don't know," says Nintendo President Hiroshi Yamauchi. "The game business happens to be one thing they know nothing about."

ONLY ONE TAKER. Microsoft has stumbled before. Take interactive TV. In the past three years, the company has invested more than $8 billion in cable companies to secure a spot for its set-top-box software. But after nearly a decade of tinkering with interactive TV, Microsoft's set-top-box software is still hard to find. Only one cable company is using it: Globo Cabo in Brazil, which will begin a trial in 250 homes in Sorocaba later this month.

When Microsoft targets a market, it often perseveres. Its MSN portal and Internet-access service languished for nearly six years. Today, it's the second-most popular portal on the Web, behind Yahoo! Inc. (YHOO ) And its Web-access service is second only to AOL. Microsoft was able to dip into its war chest, investing $100 million in RadioShack Corp. (RSH ) and $200 million in Best Buy Co. (BBY ) in exchange for those retailers promoting MSN's access service--something smaller competitors can't afford to do. "MSN, through an incredible war of attrition, has built an incredibly powerful franchise," says Merrill Lynch analyst Henry Blodget.

Microsoft shows the same dogged persistence when it comes to basic research. Even while its latest products are waiting on the launchpad, it continues to pour money into R&D in search of the Next Big Thing. Gates is so jazzed about the future of software that he stepped down as CEO 18 months ago to become Chief Software Architect. That lets him spend more time with the company's 620 researchers. Walk through the warren of shoebox-size offices, and you'll find engineers working on the most vexing problems, such as getting computers to understand what you say. Gates gets wound up like a kid over stuff like creating a computer that watches your actions with a small video camera and determines if you're too busy to be interrupted with a phone call or e-mail. "The whole idea of valuing the user's time, that's the Holy Grail," he says, jumping out of his seat with excitement.

Perhaps the most ambitious research foray is Microsoft's 10-year march toward solving natural-language processing. It's a techie name, but the concept behind it is simple and quite powerful. It's the idea that computers will be able to respond to questions or commands in everyday language, not just computerese or a long series of mouse clicks. Combine that with speech recognition--another area where Microsoft researchers are plugging away--and one day you'll be able to talk to your computer the same way you do to another person. Microsoft has woven rudimentary natural language into such products as Office. The next step is delivering more advanced capabilities in the version of Windows due out in two years or so, code-named Blackcomb.

A lot of these markets remain a gleam in Gates's eyes. Time and again, though, Microsoft has shown it has the focus and the financial staying power to get it right eventually. That could mean we'll hear echoes of "Microsoft, bomaye!" for years to come.

By Jay Greene

With Mike France in New York, Amy Borrus in Washington, D.C., and Peter Burrows in San Mateo, Calif.

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