Bill Gates in Your Living Room

Can Microsoft control the digital home?

Meander through the corridors of Building 50 on Microsoft Corp.'s (MSFT ) campus and you might, for just one mind-bending moment, feel as if you're in the bowels of consumer-electronics powerhouse Sony Corp. (SNE ) In one room, engineers are ginning up a way to record TV programs on a PC so they can be watched at any hour. Around the corner, workers are noodling over software that makes it a snap to edit home movies and copy them onto a DVD. Still others are figuring out better methods for managing thousands of digital music files. And in the main conference room, rather than the typical corporate white boards, there is a wall-size viewing screen and a sound system that would make the neighbors call the cops--if you dared to have one in your home.

Is Microsoft, the no-nonsense king of PC software, having a midlife crisis? Not at all. The software giant is trying on a new persona for a new environment. With PC sales expected to decline for the second straight year as corporate spending withers, Microsoft is aiming its big guns on entertainment goodies for the home. It's spending more than $2 billion building and marketing its new Xbox game console. And it's sure to spend millions more on everything from its UltimateTV video-recording service to an online subscription music service to a handy wireless electronic tablet for the home, code-named Mira. On Jan. 7, at the Consumer Electronics Show in Las Vegas, Chairman William H. Gates III revealed Microsoft's next-generation technologies aimed at making the PC the electronic hub of the digital home. They'll route music, movies, TV programming, e-mail, and news between the Web and PCs, TV set-top boxes, gadgets, and stereo speakers. "Everything in the home will be connected," predicts Gates. And if he gets his way, most of the gizmos will use Microsoft software.

That's why Building 50, brand-spanking new, is the digs for the software maker's eHome division, a skunk works of more than 200 engineers responsible for turning Microsoft into the Sony of the 21st century. The digital home is the biggest market push by Microsoft since it launched its assault on server computing a decade ago, and the front-line troops are stoked. Says J. Allard, one of the architects of the company's Internet strategy and now the lead technologist on the Xbox: "This is a way to build a whole new Microsoft."

And perhaps a whole new industry. In the next half-decade, Microsoft hopes to spark a revolution in consumer technology that transforms people's home lives every bit as much as the PC has changed their work lives. The concept is far from new, but Gates and other tech execs say the timing is right now that the Internet has made many consumers more tech-savvy. Indeed, other computer companies are doing the same--from Seagate Technology, which is making storage devices for consumer electronics products, to Apple Computer Inc., which debuted its new iMac for the home on Jan. 7. Says Gates lieutenant Robert J. Bach, who oversees the Xbox group: "The technology revolution has changed the way people do business. The next 5 to 10 years will be the digital entertainment revolution."

Microsoft is banking on its consumer business, along with server sales, to help revive growth, which was stuck at about 10% for much of last year. Morgan Stanley Dean Witter & Co. estimates that Microsoft will earn $9.3 billion in the fiscal year that ends on June 30, on revenue of $28.8 billion. In fiscal 2003, it expects Microsoft's earnings to climb to $11.7 billion on sales of $32.7 billion. Much of that growth will be driven by consumer sales, which include the MSN online service, Xbox, and games. This year, sales from the consumer group will account for 12% of Microsoft's total business. In fiscal 2003, that will jump to 18%--just shy of the 21% that's expected from server products. That's one reason why Microsoft's stock is up more than 50% in the past year, to $70. "This is a large market," says CEO Steven A. Ballmer. "There's a great chance to add value. And anytime there's a great chance to add value, there's also a great chance to make money."

The consumer push comes at a time when the company seems to be coming out from under the cloud of its antitrust woes. Unless nine dissenting state attorneys general succeed in beefing up the remedies, a settlement with the Justice Dept. and nine other states will do little to prevent Microsoft from using the power of its Windows desktop monopoly to help it win new battles in the consumer realm.

For all of Microsoft's power and ambitions, though, the digital home may turn out to be the toughest market it has ever tried to crack. At best, Microsoft will be one of several top players, but it will never dominate digital entertainment the way it does PC software. Analysts expect the markets for video games, consumer online services, home networking, and interactive TV software to collectively top $63 billion in 2005. Microsoft could win in areas such as home networking, where its PC hegemony gives it an advantage. But it will lap in markets such as video game consoles and online services, where entrenched rivals rule.

Indeed, AOL Time Warner Inc. (AOL ) has a huge lead in the online service business with 33 million subscribers to Microsoft's 7 million. And Sony may be even harder to beat. The world's leading consumer-electronics brand, Sony makes every key piece of hardware--from PCs to set-top boxes to game consoles. Microsoft's focus is primarily the software that goes inside the machines, and so its success depends, in part, on the smarts of its hardware partners. "Ultimately, it's the hardware that provides the great consumer experience," says Sony President Kunitake Ando.

Moreover, Microsoft has been missing the consumer gene for years. All of its major consumer-electronics gambits so far have ended up as disappointments. Its WebTV Internet-access service stalled at 1 million subscribers, and its interactive-TV technologies have gone nowhere. The company's digital stereo speakers and PC-connected telephones were introduced in 1998 only to be abandoned a year later. And the gee-whiz technology in Gates's suburban Seattle mansion--which includes electronic pins that each person wears to signal a preference in digital art, music, and temperature--has required as many as 50 servers, not the stuff of a simple consumer experience. Says Minoru Arakawa, who retired on Jan. 8 as the president of Nintendo of America Inc.: "Microsoft is spending a lot of money, but they are beginners."

Even Microsoft's allies are tinkering with rival software, not convinced that Microsoft will be the end-all in the digital home. Microsoft buddy Intel Corp. (INTC ) has used non-Microsoft software in some of its Web appliances. "There will be a lot of experimentation," says Intel CEO Craig R. Barrett. While he thinks the PC can be a hub for home networking, in some cases it will be on the periphery. One alternative to the PC emerged on Jan. 7 when startup Moxi Digital Inc. debuted a system for managing home entertainment via a set-top box.

Microsoft is playing to win, though. It's going about this with the patient, war-of-attrition approach that has been so successful in the past. The seeds of this assault were planted in March, 1999, when Microsoft execs gathered at a retreat on the shores of Puget Sound to ponder their strategy for the home. Gates, Ballmer, and Bach wondered if they could build a new generation of consumer devices based on PC technologies.

Around the same time, a handful of engineers deep inside the company wanted to build the hottest-ever game console. Nat Brown, one of the ringleaders, recruited Allard to get behind the project during a day they spent together playing video games at Allard's cabin in the Cascades. "The heart and soul of this thing came from the garage--5 to 10 dreamers who wanted to take Microsoft into a new space," says Allard.

Microsoft's brass decided to attack on all fronts. Microsoft seemed to turn the corner at the 2000 Consumer Electronics Show when it abandoned its tradition of setting up a series of booths to market its products. Instead, it created a model home on the showroom floor--complete with Jetson-like gadgets and a family of actors--to show people how digital technologies might shape their future. "That's when the whole company got the `aha!"' says Microsoft consumer products strategist Craig J. Mundie.

Microsoft decided it would build off what it sees as its "three pillars" for the digital home: MSN, Xbox, and Windows XP, which includes home networking technology. That way the software giant can leverage its strengths into new home entertainment categories such as online music. The plan now is to create specialized products in a wide range of markets rather than try to build an uber-box that would handle every function from gaming to spreadsheets. So, Microsoft teams are pursuing separate tacks on game consoles, consumer PCs, interactive TV, digital home appliances, handheld gizmos, and online services. "The way you get to our vision is by building individual products that are the best in their own categories," says Gates. "It's like Microsoft Office. We built that with Word being the best, Excel being the best. They all had to be the best before the whole integration thing came together."

Although Gates says no detailed plan exists for integrating all these home products, Windows and the PC are central to the strategy. That's why Windows XP, the newest version of the company's operating system, is so important. After years of producing crash-prone software, Microsoft finally delivered an operating system that is more like a consumer appliance. Launched on Oct. 25, XP seldom crashes and is easy to use. With XP, it's a snap to edit home movies or burn CDs, programs that are likely to greatly expand the use of the PC in the home. And Windows XP'S home networking technology lets the PC automatically discover and connect such networked devices as digital audio receivers. "We're moving Windows to the living room," crows James E. Allchin, group vice-president in charge of Microsoft's operating systems.

Microsoft also is taking a page from its past playbook: It's creating an ecosystem in which hardware makers and software developers can create products based on Microsoft technology. "We have partners who are doing cameras and screens and lots of peripherals that will let you reach out to all the different things around the home," Gates says. Already signed up: Samsung, Hewlett-Packard (HWP ), and NEC, all of which are developing media center PCs that use eHome technology.

Those PCs will use a Microsoft software code-named Freestyle. In addition to peripherals such as a mouse and keyboard, PCs loaded with Freestyle would include a TV tuner card to connect to a cable service and a remote control to navigate the system from a couch. That way, consumers could organize their music files or home movies while they're sitting at a desk and later, use the remote control to select tunes or videos from anywhere in the room. The first-generation, all-in-one Freestyle PCs will have all the functionality of a TV and a stereo. The target market: college students and apartment dwellers who might not have the space or budget for a PC, a TV, and a stereo. The second-generation Freestyle PCs will focus on the broad consumer market, selling boxes that sit next to TVs around the house and connect back to the main PC.

The first major connected-home product from Microsoft will be a gizmo code-named Mira. By next Christmas, consumers will be able to buy a flat-panel monitor that detaches from its stand and continues to connect wirelessly to the PC from anywhere in the house. With a stylus tapping icons or scrawling letters on a touch screen, Mom can check e-mail from the kitchen, the kids can chat with online buddies from the couch while watching MTV, and Dad can shop at from the back porch. ViewSonic Corp. and Wyse Technology Inc. will make the devices for as little as $500.

Microsoft is counting on Xbox to jump-start its digital home initiative. Already, Xbox sales are hitting the high end of analysts' expectations. Since the launch on Nov. 15, about 1.5 million consoles have been sold. That beats Nintendo's GameCube, which has sold 1.2 million units since its Nov. 18 launch. Meanwhile, Sony's PlayStation2, out since Oct. 25, 2000, rang up 2.5 million unit sales in North America this Christmas season.

Even the bookish Gates has been sucked in by Xbox. Although he was never much of a gamer before, he took a test version on his vacation in October. Each night, after putting their two children to bed, Gates and wife Melinda plopped down on the couch and found themselves absorbed by Fuzion Frenzy, a collection of 45 arcade-style games. "We played four hours straight the first day, since it was so cool," says Gates.

While Xbox is designed first and foremost to best PlayStation 2 and GameCube, the connected-home vision is a constant undercurrent. Microsoft built networking technology into the Xbox that will let gamers compete against one another from across the street or around the world. The company plans to launch its Xbox online gaming service by the middle of this year. Robert A. Kotick, chairman and CEO of Activision Inc., the No. 2 game publisher, believes online tournaments will be immensely popular. "It's a lot of fun to waste time playing video games. It would be a lot more fun wasting time playing video games and winning a trip to Hawaii as well," Kotick says.

For all the nifty technology, Xbox still needs killer games. And analysts don't count any sure blockbusters in the initial bunch of 20. "What's the must-have game that's going to get people to pay $300 to buy this console? I just haven't seen it," says analyst Edward Williams of Gerard Klauer Mattison & Co. He expects Xbox to capture about 10% of the game console market during the five-year life cycle of game consoles that's just beginning. So, while Xbox could become a sizable business for Microsoft, it's only a piece of the puzzle.

The companies that win biggest in the home will likely be the ones with the most direct ongoing relationships with customers. Right now, that's AOL Time Warner (AOL ), which touches 46 million subscribers with its online and cable businesses. "The value is in the consumer relationships, not the technology. It's about subscriptions," says AOL Time Warner Co-Chief Operating Officer Robert W. Pittman. AOL is collecting $24 a month from most of the 33 million consumers who connect to its online service. And its Time Warner Cable unit gets another $54 per month, on average, from its 12.7 million homes. Microsoft can't touch that. It's lucky if it sells a home PC user a $90 operating-system upgrade every three or four years.

And when it comes to mastering consumer technology, Microsoft sucks Sony's exhaust. As cool as Microsoft's Freestyle sounds, Sony (SNE ) already has introduced its Vaio MX media center PC, which does everything that Freestyle aspires to. Microsoft's Mira is nearly a year away. But more than a year ago, Sony introduced its Airboard in Japan, a flat-panel screen that can be used to check e-mail, surf the Web, and play video games. And Sony is developing networking technology, dubbed Feel, that will make it easy to connect all of its devices to one home network.

Still, no company is better fixed than Microsoft to make long-term investments in the digital home. With $36 billion in cash, it can afford to invest heavily, experiment broadly, and wait patiently for the payoff. Microsoft's history is loaded with examples of perseverance. MSN foundered for years before Microsoft figured out how to turn it into one of the top destinations on the Web. For most of a decade, its server software was the laughingstock of corporate computing. This year, it's expected to claim 47% of the market.

So it's not surprising that Microsoft is confident it will win in the home. "A lot of this stuff isn't a question of, `Will the dogs eat the dog food?' It's `When?"' says Microsoft's Mundie. Maybe so, but competitors such as Sony have thrived by offering customers steak rather than dog chow. If Microsoft can't match Sony, it will end up on the outside of the digital home, looking in.

By Jay Greene in Seattle, with Steve Hamm in New York, Catherine Yang in Washington, and Irene M. Kunii in Tokyo

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