Sun's Defiant Face-Off

Scott McNealy sees himself as the last challenger to Microsoft's bid for Web domination. Is his plan realistic? Or grandiose bluster?

In this sorry economy, Scott G. McNealy says he thinks about quitting his job as chief executive of Sun Microsystems Inc. (SUNW ) every single day. With a 2% stake in Sun that's worth $668 million, McNealy would just as soon focus on playing hockey, perfecting his scratch golf game, or hanging out with his three young sons and pregnant wife. Instead he's in the office, coping with the worst tech slump in 16 years. Sun has been losing money for the past two quarters and doesn't expect to see a profit until next summer. That has forced McNealy finally to give up his dream of avoiding layoffs. On Oct. 5, he became one of the last computer executives to hand out pink slips.

Why doesn't he just chuck it? He can't, he says, because now he has an even more crucial job ahead of him: Stopping archrival Microsoft Corp. (MSFT ) from ruling the Web. "It really is mankind against Microsoft. And mankind needs a bit of a break right now," he says. His words are trademark McNealy--over the top, with a comic twist. And one can't help but wonder if this is just another theatrical moment in the longstanding feud between the two companies. McNealy insists it's not. He drops his usual patter to admit: "I know this sounds like ranting and raving." But he says he's in dead earnest. "This is why I don't quit this job. I've got more than enough money, but I don't want to leave my children to a Microsoft-only world."

Especially now. McNealy is incensed about the Nov. 2 announcement of a proposed antitrust settlement that he thinks barely raps Microsoft on the knuckles. "It's garbage," he says. "We've got a much more unfettered monopolist now--one that will hurt innovation and take away people's choice." Like many computer-industry execs, McNealy is dismayed by a settlement he says will do little to curb Microsoft's anticompetitive behavior. If approved by a federal judge, the agreement will allow PC makers to fiddle with Microsoft's Windows software so they can prominently feature programs made by rivals. It will force Microsoft to share technology that lets outside programs, such as streaming media, work well with Windows. And Microsoft will have to disclose its Windows pricing so that it can't use it as a weapon against PC makers who install non-Microsoft products.

The problem is, those remedies are aimed at the PC realm, where Microsoft already dominates. The settlement does nothing to keep Microsoft from taking unfair advantage of its Windows monopoly in new markets by packaging Windows with services such as its Passport I.D. authentication, instant messaging, and videoconferencing. McNealy believes Microsoft is now free to use its monopoly unfairly to try to dominate the Internet as thoroughly as it does the PC market.

How does he plan to slow it down? By pushing Sun into overdrive to create technology for a new generation of Web services that will compete with those being rolled out by Microsoft. He doesn't have to beat Microsoft--just create a viable alternative. Until now, the Internet has been about Web sites that people beeline to for stock trades, plane tickets, filling out expense reports, and the like. In the next phase of the Net, these sites will communicate with one another to do a series of tasks on your behalf. If, for example, your flight is delayed, a service would let you know by pager while changing your online calendar and notifying your car service of a new pickup time. That might trigger another service to alert your next business appointment that you will be late.

CRUCIAL FACE-OFF. Web services are shaping up to be the next big frontier in computing. Technology leaders foresee a day when all manner of jobs, from managing relationships with customers to coordinating with distributors, will be handled by services delivered over the Net rather than with traditional software programs, phones, and faxes. While it's too early to tell how big the market will be, this is one topic where McNealy and Microsoft agree. "Everything in the world will be in Web services," says Microsoft Chairman William H. Gates III. If he's right, the companies building the underpinnings for these services could become the tech powerhouses for years to come. And if Microsoft wins, it could maintain the kind of hold over the vast reaches of Internet computing that the company now has in the PC world.

That's why a face-off with Microsoft is so crucial for McNealy. "I'm the only one left," he says, who can put the technology pieces and partnerships together to offer an alternative to Microsoft. And, he says, he's the only computer exec standing who does not depend on Microsoft in some way. Computer makers rely on Windows for their PCs, servers, and handhelds. Most software makers build their programs to work on Windows. "McNealy sees it as part of his responsibility to maintain the checks and balances in the industry," says John O. Wilkerson, president of global alliances at Electronic Data Systems Corp., a partner of both Sun and Microsoft.

That's nonsense, say Microsoft executives. Gates says the antitrust settlement agreement is "fair and reasonable and, most important, is in the best interests of consumers and the economy." Microsoft top brass dismiss McNealy's stand as rhetoric that's "higher than usual and emptier than usual" because he's trying to take the focus off how poorly his company is doing these days. "Scott's a comedian, and he's especially good when he doesn't have any product to sell," says Robert Muglia, a Microsoft group vice-president.

There's little question that McNealy would have a better chance against Microsoft if his company's fortunes hadn't taken a dive this year. With its core dot-com and telecommunications markets in tatters, Sun's sales plunged 43% in the quarter that ended on Sept. 30. Faced with vicious price-cutting in the server business by Dell Computer Corp. (DELL ) and a resurgent IBM (IBM )--Sun's No. 1 rival in corporate computing today--Sun has lost $268 million in the past two quarters. And some of its newer initiatives put it in direct competition with its allies, including software maker Oracle Corp. (ORCL ). Meanwhile, Microsoft's Windows server operating system software is gaining market share, rising from 20.6% in 1999 to 27.7% for the first half of this year, according to Gartner Dataquest. Sun's stock price is down from 55 a year ago to 12 today. "I think they're in free fall," says one rival CEO.

NEW SUNRISE? McNealy has been hearing about the demise of Sun since its inception 19 years ago. He concedes that the economic environment is tough, but notes that it's tough on everyone. Sun will weather the downturn, he says, because it has robust technology that companies need to handle their biggest computing chores. He gets backing from analysts, who praise Sun for not cutting its research-and-development spending and believe it will recover next year. Merrill Lynch & Co. predicts that Sun's revenues will rise 20%, to $15.9 billion, next fiscal year, and will deliver $457 million in profits.

Vital to a turnaround is Sun's push into Web services. It is pulling together a platform for building Web services called Sun ONE that will compete with Microsoft's services technology, called .NET. These platforms are behind-the-scenes technologies that corporations and independent software makers can use as building blocks for creating services that people subscribe to. Sun's foundation pieces include its Solaris operating system, Java programming language, and software tools. Sun also is merging disparate software into this jumbo package, including its e-commerce software. And it's overhauling all the pieces to comply with new Web-service technology standards by the middle of next year. At that point, Sun hopes to start selling its package of software preconfigured on its computers--along with storage drives and other gear. The goal: giving Web-service providers everything that they need in one easy-to-use package.

McNealy will have to move fast if he hopes to keep pace with Microsoft. Once written off as a rich has-been from the PC era, the software giant has come storming back. Last year, blowing past Sun, Microsoft announced .NET, its platform for building Web services. And on Oct. 25, the company released a new version of its PC operating system, Windows XP, that is packed with online services, including Passport, which lets people avoid having to type in a password each time they visit participating Web sites.

While the antitrust settlement does little to slow Microsoft, McNealy says all the scrutiny of the software giant has had one favorable result for him. There's increased support from companies in media, travel, and other markets that share his concerns about Microsoft's Web plans. They fear that Passport and other services will allow Microsoft to collect reams of personal data on buyers and their habits that give it a leg up in offering yet more services. Those fears persist even though Microsoft has pledged not to track buying habits or market its own services to Passport subscribers.

Still, to combat the perceived threat, McNealy has taken the lead in establishing Project Liberty--an alternative to Passport. Project Liberty is a 34-company standards body that hopes to map out a blueprint so that any company's Passport-like services could hook up to any others. "My concern with Microsoft is that they're going to get between me and my customers," says a telecom executive who is one of Project Liberty's co-founders. "Microsoft has managed to piss off every one of us."

Will all this be enough to restore Sun to its former glory? Probably not. Sun's peak 60% revenue-growth rates are a thing of the past. Because its high-end server technology is more popular with corporations than Microsoft's, Sun should be able to hold or regain market share when the economy recovers. But server margins are tumbling because of increased competition from IBM at the high end and from Windows- and Linux-based servers at the low end. So, to boost profits, Sun will have to do well against Microsoft on its home turf--software.

Sun is in a better spot when it comes to Web services. Even though it's trailing Microsoft, its rival Sun ONE contains Java software, which is popular with corporations that have used it to create Internet programs. That means Sun should be able to gain ground once it has Sun ONE ready next year. The key question: Will Sun ONE be a strong enough alternative to prevent Microsoft from dominating the future of computing? If McNealy falls short, Sun could be well-liked by fans but increasingly irrelevant. And Microsoft could be stronger than ever.

That would be a devastating defeat for McNealy, who has deeply held beliefs about how companies should do business. His views were formed during his teenage years in suburban Detroit. That's when McNealy watched his father, a vice-chairman at American Motors, lose out to General Motors Corp. (GM ) and Ford Motor Co. (F ). "If he sees someone go over the edge [ethically], it upsets him a lot more than it bothers most people," says his father, Bill. "I think it comes from being around an underdog as a kid and watching us struggle."

What upsets McNealy about Microsoft is how it has used its monopoly to beat software competitors such as browser maker Netscape Communications Corp. That, he believes, suppresses innovation by discouraging other tech companies from developing rival products. The losers, he says: consumers and the economy.

Sun's philosophy is in stark contrast to Microsoft's. Sun created its Java programming language in 1995 so people could write Web applications that run on any computer. Sun shares management of Java with more than 200 companies that have licensed it. Even though some Java licensees have griped, Sun doesn't control Java in the way Microsoft controls Windows. McNealy's strategy is for Java to fuel overall tech spending and for Sun to grab as much of that new business as possible.

Because of Sun's heritage, Web services should have been Sun's game. Since McNealy and three pals formed Sun in 1982, their philosophy was that computers that were networked together would be far more useful than stand-alone PCs. That's why every product in Sun's history has been based on the protocols at the heart of the Internet--the biggest network of all.

What went wrong? Sun became a victim of its own success. In the late 1990s, with sales racing, McNealy and his team had their hands full managing the business--no small feat, given that the company's staff grew by 33%, or 10,000, in fiscal 2000. And with cash-flush corporations still pouring money into Java-based projects, Sun execs figured all was well.

HESITATION. Meanwhile, Microsoft saw an opportunity to at last become a Net visionary--and executed perfectly. It grabbed the lead in advancing an industry standard called XML. A way of describing digitized data--whether they're specifications for a car part or the format of an insurance claim--XML is critical to Web services, since it lets data be passed among all kinds of computers and software programs. With Microsoft taking the lead, Sun hesitated and fell behind.

Microsoft's unveiling of .NET in June, 2000, was a wake-up call for Sun. While McNealy immediately dubbed the project ".Not," many Sun insiders were impressed by how much meat there was on Microsoft's plan. They fumed at how .NET seemed to remake Microsoft's image overnight. It was suddenly the leading Web-services pioneer. Some Sun execs feared Web developers might migrate to the .NET camp.

Sun got moving, albeit slowly. A nine-person task force led by Chief Technology Officer Greg Papadopoulos began to pull together Sun's Web-services plan. But the company did not fill out the details until last month. In mid-2002, Sun promises to release server software that will let corporate customers offer XML-based Web services to close partners. Technology to take that to the next level, to enable any of these Web services to work with those of any other company, won't be out until 2003. "Sun has not been a leader in Web services at all," says Gartner Group Inc. analyst David Smith. "Microsoft is much more of the visionary than Sun."

It's not just in terms of vision that Sun lags, but also in execution. Microsoft has delivered a steady beat of new products based on its .NET strategy. IBM also is ahead of Sun, say analysts. Already, 50,000 of its customers use its technology, called WebSphere, as a foundation for creating Internet applications such as programs that manage customer relationships. On May 14, it updated the software so it can be used as a basis for building Web services.

McNealy denies Sun is behind Microsoft. Still, he's trying to make Sun think like a software company. On Oct. 5, it announced it was taking over AOL Time Warner's 50% stake in the iPlanet joint venture, maker of Web site and e-commerce software. That will let Sun merge this group into the rest of the company. Rather than have a separate sales staff, Sun's 12,000 sales reps also will sell software on their rounds.

Will the software push work? It's a long shot at best. While Sun is great at creating buzz for a new machine, "we just never have done a good job of marketing software," admits President Edward J. Zander. Consider application-server software, which dishes out applications for such tasks as managing a supply chain over the Web. Sun controlled 40% of the application-server software market in the mid-1990s. Since then, Sun's share has plunged to about 11% as IBM and BEA Systems have taken the lead. That smarts--because these days many developers create Web programs that work on application servers rather than on operating systems, such as Sun's Solaris. "Sun is just way behind," says Scott Hebner, IBM's director of marketing for WebSphere.

TRUST FACTOR. While Sun has a long way to go on the software front, interviews with corporate buyers and software developers suggest that, long term, Sun's technology is likely to be a viable alternative to Microsoft's Web services. Telekom Malaysia, for instance, uses Sun ONE technology for its iOffice Web portal for small businesses. It lets 40,000 customers store their phone lists online, make phone calls via the Net, and manage voice-mail, e-mail, and faxes--and have them delivered to their PC or read to them on the phone. Why did Telekom Malaysia not pick Microsoft? Mohamed Roslan Sallehuddin, head of the iOffice business, says "Microsoft was not even considered because their record of technology robustness and support in our company was bad."

Sun's biggest advantage may be the trust factor it has engendered through years of backing open industry standards such as Java. Many software developers and corporate customers are confident Sun won't fiddle with Java to cut others out. In contrast, Microsoft critics say it takes advantage of owning Windows to beat other software developers. "Sun is no Mother Teresa, but they have been in a position to take advantage of Java, and they haven't. Scott has to get credit for taking a different tack than Microsoft took," says David A. Litwack, CEO of SilverStream Software Inc. Microsoft's response: It makes it possible for scads of software companies to write programs to run on Windows.

Developers of sophisticated corporate software are firmly in the Java camp: It allows them to create programs quickly for a wide variety of computers. A November survey by Evans Data Corp. showed that 55% of developers plan to use Java to develop Web services in the next year, compared with 35% for .NET. That includes some close Microsoft allies: Software giant SAP will use Java in its corporate Web services--even though it does not plan on using other Sun ONE technology. "When we went to our customers, they said: `Java is what we want,"' says Shai Agassi, CEO of the company's SAP Portals unit.

Of course, the success of Java means only that Sun gets to compete--it doesn't guarantee success. And McNealy has plenty of problems to deal with as he prepares for the coming Web-services face-off with Microsoft. One whopper: IBM. Big Blue has been selling its impressive new lineup of powerful servers at cut-rate prices to land big consulting gigs. While Sun's Unix market share declined from 38.9% to 35% between the second quarter of 2000 and this year's second quarter, IBM's lifted from 17% to 21.6%, according to IDC. Sun bounced back from a low of 31.6% in the first quarter, but, still, the price war has slashed Sun's gross margins on servers from 59% at the end of 1999 to 36% in the latest quarter.

Meanwhile, makers of PC servers such as Dell Computer Corp. continue to steal share in lower-end markets formerly dominated by Sun. Even though Windows servers have captured only 1% of the market for mid-tier and high-end servers, they have 60% of the market for low-end servers, according to IDC. While Sun's top-end Unix servers have more processing power and are considered more reliable, Windows servers have proved capable of handling demanding corporate computing tasks.

WRIGGLING OUT. Sun faces a dilemma. Unlike the PC makers, it designs its own microprocessor and operating-system software. That bill comes to more than $500 million a year. Those expenditures are essential, since they allow Sun to offer a more powerful alternative to Windows. But if Windows servers match Sun's capabilities and eat into Sun's market share, "they won't be able to maintain their margins and make the investments in software to keep up with us," says Microsoft .NET server software chief Paul Flessner.

As tough as times are for Sun, McNealy has shown that he can wriggle out of tight spots. In the early 1990s, as PC makers were gobbling up share in the market for technical workstations that made up over 80% of Sun's sales, he spotted the opportunity to expand the server business and struck with textbook efficiency.

Now, McNealy doesn't have to beat Microsoft: He just has to slow it down enough to keep it from dominating the Internet. While holding the high moral ground will doubtless help him in his quest, it won't determine who wins and who loses. That will depend on whether Sun's technologies deliver more bang for the bucks than do Microsoft's.

By Peter Burrows

Contributing: Jay Greene in Seattle, Spencer E. Ante in New York, and Jim Kerstetter in San Mateo, Calif.

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