AOL vs. Microsoft

With core operations slowing, both see future growth in the same places

On July 26, in the heart of Microsoft Corp.'s (MSFT ) Redmond (Wash.) campus, top executives at the software giant were deep into a presentation aimed at wowing Wall Street analysts. They started ticking off the technological triumphs in their upcoming Windows XP operating system and their new Xbox game player, when up popped a slide entitled "How to Beat AOL."

Microsoft has had many formidable adversaries through the years, including Netscape Communications, Lotus, Borland, and IBM (IBM ), but it may have finally met its match. AOL Time Warner Inc. (AOL ) is the first company in years with the guts, money, and staying power to match the giant from Redmond. And it's gaining ground in a struggle that grows fiercer by the day. In recent weeks, skirmishes between the two have erupted over issues as diverse as control of the computer desktop, AOL's potential bid for AT&T's (T ) cable unit, and pricing of online services.

The latest: On July 26, the industry discovered that AOL had landed a coveted place on the desktop of the new Windows XP operating system that will ship with Compaq Computer Corp.'s (CPQ ) machines, while MSN was relegated to a slot on the Windows start menu. "All we're trying to do is let consumers find AOL instead of being stuck with Microsoft," says AOL CEO Barry M. Schuler. Separately, AOL and Compaq are expected to announce an expanded strategic partnership in mid-August in which AOL will buy large amounts of Compaq technology while the PC maker advertises across AOL properties.

Not to be outdone, Microsoft is insisting that all PC makers that put AOL on the desktop put MSN there, too. "They're trying to not let people have the choice of using our software," said Chairman William H. Gates III at the company's July 26 analysts' meeting. Privately, the company is trying to match AOL's offers to PC makers, in hopes they'll promote MSN instead, a PC exec said.

While the two companies started in different corners of the tech business--Microsoft catering to PC users and AOL to the hordes of the online generation--they're increasingly on a collision course. Why? They're both facing slowing growth in their core businesses and see the same sources of long-term salvation: anywhere, anytime Web services--from stock quotes to online music to interactive TV--delivered lickety-split to the living room, office, or wireless device. And they're using their respective grips over PCs and online users to catapult into this new world. "Neither will cede dominance in any market," says John Corcoran, Internet analyst at CIBC World Markets. "They're saying: `I'm keeping my fingers in all your pies, and you're keeping a finger in all mine."'

Tensions are only increasing as the scheduled Oct. 25 launch of XP draws closer. In June, AOL tried and failed to win a permanent slot on the new operating system after prolonged negotiations with Microsoft. That was a big strategic blow. But the government's antitrust case is giving AOL a once-in-a-lifetime chance to try to change the way Microsoft leverages its operating-system monopoly. According to industry sources, AOL supports a plan to force the software giant to license Windows to rivals who could then configure it their own way--an idea that was floated in the past but lacked wide support.

Both companies have big arsenals and little choice but to go mano-a-mano as they pursue the same markets. At its essence, this contest will be a duel between software vs. content. Microsoft is betting that its ubiquitous Windows operating system and its lock on the allegiances of software developers will win the race, while AOL is just as sure that its control over content and online subscribers' loyalties will triumph.

Both are taking whacks at each other's strongholds. Microsoft hopes its .Net technology, which lets PC software programs and Web sites communicate with one another, will lure PC users with a single, convenient sign-on to a raft of new services on the Net. With one click, consumers will be able to order their online broker to buy 100 shares of a company, transfer $1,000 from their bank to their brokerage, and update their personal stock-portfolio program. For this service, Microsoft will levy a small charge.

Meanwhile, AOL, fresh from its $103 billion acquisition of media giant Time Warner this year, is raring to tap Time Warner's enormous hoard of traditional print, film, television, and music content for distribution over the Net. AOL doesn't need to search for a market: It already has 30 million online subscribers primed to be guinea pigs for new services. When it launches potentially lucrative new offerings, such as online music or interactive TV, it will have a significant head start over Microsoft. What's more, AOL is trying to skirt Microsoft's iron grip over the PC by pushing TV, Sony Playstation, and other connected devices. Over the long term, predicts Mike Homer, a Netscape veteran and CEO of Kontiki, a Silicon Valley startup, each is likely to maintain its sphere of influence. "AOL will win in the living room, and Microsoft will continue to march forward on the PC."

PRESSURE ON CONGRESS. Meanwhile, look for the dogfight to move into new battlegrounds. One of them is law and policymaking. AOL has been lobbying Congress on Microsoft's business plans and has talked to the Senate Judiciary Committee about the competitive issues surrounding Windows XP. In early March, AOL also briefed staff at the National Association of Attorneys General on the new operating system.

On another front, AOL believes that a good long-term remedy to the Microsoft antitrust case would be forcing the company to offer a version of the operating system to PC makers or other rivals, according to industry sources. AOL declined to discuss the idea. Such a proposal, which would be more politically acceptable than a breakup, was closely considered by trustbusters last year. Industry reaction to the idea, which would allow PC makers to load up their own bundle of applications rather than being forced to take those Microsoft chooses, is mixed. "I love it," says Gateway Inc. (GTW ) CEO Theodore W. Waitt. But it's not clear that other PC makers agree. One former Dell Computer Corp. (DELL ) manager who has experience working with Microsoft said that while it might give PC makers more choice, it would also make configuring systems more complex--a big no-no in this time of cost-cutting. "It would make life more difficult for any PC [maker]," he says. Microsoft spokesperson Vivek Varma would not discuss the details of the idea and dismissed the proposal as having "no credibility and no weight."

Broadband is another arena where the combat is heating up. Both companies are working behind the scenes in the bidding for AT&T Broadband to keep the nation's leading cable operator out of the grasp of the other. Both AOL and Microsoft are betting that upgraded digital cable lines will be a winning conduit to deliver fast Internet services. AOL, especially, doesn't want to lose its dominance in Internet access when consumers migrate to broadband. And Microsoft wants to sell the software powering the set-top boxes that bring broadband services to the living room. If too many cable guys fall into AOL's camp, its market shrinks dramatically.

The battle was drawn after Comcast Corp. (CMCSA ) made a bid for AT&T's cable assets in early July. Within two weeks, AOL execs met with AT&T in New York, according to industry sources. Under discussion: A new spin-off combining AT&T Broadband with AOL Time Warner's cable operations, with AT&T holding a 40% share. Comcast execs believe they can beat an AOL counteroffer with the help of Microsoft, which owns nearly 5% of Comcast.

No doubt about it, these two giants are going to collide more frequently as they rush into the broadband future. Consumers watching the brawl can only hope that this clash of the titans will mean better services for them.

By Catherine Yang in Washington, with Jay Greene in Seattle, Andrew Park in Dallas, and bureau reports

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