Can MSN Play David to AOL's Goliath?

It's still a distant No. 2 in market share, but opportunity knocks

Taped onto a stop sign on Microsoft's (MSFT ) Redmond (Wash.) campus is a piece of paper bearing three letters: AOL (AOL ). The message: Stop America Online Inc. After trailing AOL for years, Microsoft is mobilizing to steal market share from the top dog in cyberspace. It's rolling out a new version of MSN, gearing up for the switch to broadband Internet access, and signing up new customers at a rate of over 6,000 people a day. Says vice-president Yusuf Mehdi: "We've never been in a better situation to bring some heat to America Online."

Considering the turmoil at AOL Time Warner, he's probably right. The AOL unit's second-quarter revenues dropped 3% from the same period a year ago, mostly due to an ad slump. AOL, with 26.5 million U.S. customers, is triple the size of MSN, but its growth of new subscribers has slowed to 13% over the past 12 months, down from 21% the previous year. The July departure under pressure of chief operating officer Robert W. Pittman, who had been the acting head of AOL, leaves the unit without a strong hand on the rudder. And now there's a federal investigation into its accounting.

While AOL is foundering, MSN is gaining strength. The number of MSN subscribers surged 34% over the past 12 months. And analyst Ken Kiarash of the Buckingham Research Group predicts it will jump another 26% over the next year.

It's an awkward time for AOL to be playing defense. An accelerating switch to broadband Internet access could reshape the landscape. Analysts expect broadband users to triple to 32 million between now and 2005. Meanwhile, dial-up Internet access is expected to stall this year at 54.4 million households and then decline, according to researcher Yankee Group. Unless AOL can convince customers to stick with it when they shift to broadband, it faces a massive loss of subscriptions.

Microsoft aims to take advantage of the broadband upswell. AOL has done little to sign up customers for broadband access--which number only in the hundreds of thousands for both companies. But Microsoft in June began offering MSN nationwide via broadband telephone lines. The price is $39.95 a month, vs. AOL's fee of $44.95. And starting later this year, MSN will be packaged with broadband offerings from Verizon Communications, Qwest Communications International, and other telephone carriers.

With MSN 8 due out in the fall, Microsoft will for the first time have a leg up on AOL in features and functions. The new version offers photo editing and the Encarta digital encyclopedia--things AOL doesn't have--as well as improved parental controls and junk e-mail filters. "If you look at AOL feature by feature, AOL isn't as good," says analyst Charlene Li of Forrester Research Inc. To make that point with consumers, Microsoft plans on doing price promotions against AOL, plus a series of "Pepsi vs. Coke" TV advertisements.

Still, AOL denies that it's vulnerable. The company plans on launching its own improved service this fall. While execs won't divulge all the details, they say the new AOL will contain many of the same innovations as MSN 8, plus other goodies such as Google search. A separate version of AOL tuned to run via broadband connections is due out later this year. AOL spokesman John Buckley scoffs at Microsoft's aspirations. "Last I checked, at its peak, 18 people switched a day from AOL to MSN. Based on that, in the year 3000, they may well have caught up," he says.

But AOL can't afford to take Microsoft lightly. Time after time, the software giant has matched the capabilities of rival's products and then used its Windows monopoly and its vast cash horde to gradually gain market share. If AOL doesn't sort out its management problems and pick up the pace of innovation and marketing, its name could be added to the long list of those who lost battles of attrition with Microsoft.

By Heather Green in New York with Catherine Yang in Washington

— With assistance by Catherine Yang

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