Denise Caruso Microsoft Everywhere Software is clearly the lingua franca of our era, and Microsoft Corp. has a commanding lead in the race to develop and control many of its most promising technologies and markets. Chairman Bill Gates and his lieutenants speak confidently -- and quite seriously -- of a time not far off when Microsoft software will be everywhere that software can reside, from wristwatches to dishwashers to interactive TV networks and programming, and all points in between. Such heady talk is far removed from the prosaic discussions of word processors and spreadsheets that concerned the company in years past. The personal computer as a productivity tool has made Microsoft a very wealthy company -- profits continue to hover at about 25 percent of revenues, which for the year ending in June 1994 were approximately $4.65 billion. But to evolve beyond it, Microsoft must successfully answer a fundamental question: What is the new business model for the consumer market that Microsoft is pursuing so ardently? The company's strategic moves over the past few months -- most notably its announcement of the Microsoft Network, its merger-in-progress with Intuit, and its alliance with Visa International -- suggest that Microsoft already knows the model which served it so well in the personal computer industry doesn't work in the consumer market. As a result, the company's reach has greatly expanded to embrace a revenue model based on transactions and royalties as well as packaged goods. It is a strategy fraught with risk on many fronts for many players, but if Microsoft can assert its dominance as successfully as it did in the PC market, the rewards will be staggering. To an unprecedented degree, players in the communication, information and entertainment industries -- notoriously independent no matter what their size -- could choose to join destinies with the world's largest software company, paying Microsoft billions of dollars each year for the digital tools and platforms they use to produce and deliver their electronic goods and services. How Microsoft dominates the personal computer industry Microsoft's business model for the personal computer industry is relatively straightforward; it consists of licensing the operating system (a critical piece of software that, like the grooves in a record album, allows the computer to "play" application software), selling application software (i.e., spreadsheets, word processors and databases) and selling tools and/or developer support to companies like Lotus Development and Borland International who create application software. Microsoft makes its real money from the applications that it develops in- house. ((It maintains a staggering hold on the market: applications represented 60 percent of Microsoft's $1.57 billion in pre-tax profit in 1994, with operating systems contributing 35 percent and hardware 5 percent.-- waiting for updated figures from MS)) Its enormous success gave Microsoft the leverage to start price wars in the applications business -- especially by offering its applications bundled together in what are called "suites," such as Microsoft Office, for a fraction of the standalone price. As a result, competing companies that were once high-flyers are barely profitable in their best quarters. Operating system licenses -- once Microsoft's central revenue source -- are purchased by PC manufacturers such as Compaq or Dell for a flat fee, usually $30 to $40 per box. Its initial entry in the market was the MS-DOS operating system, which has evolved to include the Windows graphical user interface. Although the revenues from operating system licenses are relatively small, the software itself continues to be strategic: the key to Microsoft's success in the PC business is that it has linked its three product areas into an interdependent chain. Once the operating-system platform is dominant, anyone in the chain -- from applications developers to hardware manufacturers -- must march to Microsoft's drum in order to stay connected to its millions of customers. How does this model map to the new media? As a business model, this simple chain -- operating systems, applications, tools -- maps pretty well to the CD-ROM market, where the popularity of the new medium continues to drive sales of Windows PCs into the home. Microsoft is investing heavily in consumer-oriented software such as CD- ROM titles and children's creativity applications. Its Microsoft Home division has already introduced more than 70 products -- a number which includes multimedia titles, home applications and hardware such as ergonomic keyboards -- and hopes to ship 100 by the end of summer 1995. Because of its dominance in the PC business, Microsoft has essentially established Windows as the preferred platform for CD-ROM development; nearly every company developing titles creates them first for Windows because the installed base of Windows PCs in the home has far surpassed that of its closest competitor, the Apple Macintosh. But the model doesn't work so well in the truly promising (i.e., high volume), transaction-based technologies such as interactive TV or online services. Unlike the PC business, where it has ultimate leverage over all the links of a relatively short chain, Microsoft has no native influence in the large and existing infrastructures it wants to penetrate (cable networks, telcos and content providers) -- except that it is Microsoft. In addition, the PC software model -- which only identifies operating systems, tools and applications as revenue generators -- to date doesn't have a mechanism for generating or collecting the royalties on system usage that broadband networks and interactive and electronic media applications are expected to generate. Turning packaged goods into recurring revenues The entertainment industry and those who service it have long preferred to sell "software" that is consumed, rather than applied. Better to collect $3 per video rental, a few hundred times, or $25 a month for cable TV service, than to collect $250 for a software program that's purchased once, used every day and maybe upgraded for $50 every two or three years. Microsoft's consumer business model is focused on creating similar sources of recurring revenue. One reason for the shift, of course, is that the software application business is vast but finite. The market for business computers and software is finally showing signs of maturity. And although the home PC market is growing rapidly now, it will also eventually reach its peak, and when it does, the market for home office-style application software will peak not long after. The much-rumored (but never consummated) Cablesoft alliance between Microsoft, Tele-Communications Inc. and Time Warner in summer 1993 -- the three companies were said to be cooperating on an interactive TV system design -- was the first public indication that Microsoft was serious about entering the broadband network market. Its first major product initiative was announced in May 1994, when it took the wraps off a key software component for delivering video on demand and electronic shopping. Code-named Tiger and now called the Microsoft Media Server, the innovative design is based on a version of the Windows NT operating system, called NTAS, that uses standard PCs and cutting-edge ATM (asynchronous transfer mode) networking products to deliver video, audio, animation and information services into the home. Craig Mundie, general manager of Microsoft's Advanced Consumer Technology (ACT) group, acknowledged that Microsoft would charge licensing fees for both the NTAS and the hardware reference design. But even though Mundie and Nathan Myhrvold, director of Microsoft's Advanced Technology Group, would not admit that a royalty structure based on customer usage was in the works, the truth is that the structure of the cable system -- and where Microsoft software could reside within it -- would make it very difficult for any company to make money simply selling a one- time operating system license for interactive TV hardware. First, there aren't that many head-ends in the world where a media server can sit -- less than 12,000 in the U.S. And second, even though potential volume for home settop boxes is enormous, their extremely low margins would preclude Microsoft from charging manufacturers more than a few cents per box. Mining the new mother lode: transactions So with the profits from media servers and settop boxes thus constrained, logic dictates that a different revenue strategy is required. While Microsoft won't confirm it (and is likely still trying to figure out exactly what the market will buy), it's clear that the company is trying to win support among its potential customers for a transaction-based model that would bring Microsoft a recurring revenue stream. In fact, sources claim that Microsoft has approached cable providers with an offer to both set up and maintain the interactive-services part of a Microsoft Media Server network -- including processing customer transactions and billing. In exchange, Microsoft would receive a percentage of the revenue that each customer pays the cable company for interactive services, or a percentage of the price paid for each transaction the customer conducts over the network, or both. And based on the Gatesian theory that you should never lose a sale over price, some say he might even consider giving away the system software in exchange for a piece of the royalty stream. In this scenario, Microsoft could collect (for example) 5 percent of every $3 paid for a movie-on-demand, or 5 percent of the $20 per month that a family pays for unlimited videogame play on its ITV network. Assuming a nearly perfect world, where half of today's 59 million basic cable households will have access to an interactive TV network, and assuming again that they're all willing to pay at least $20 for the pleasure, Microsoft could collect $1.2 billion a year just on transactions without selling a single piece of software. Now that's a new business model. A double-edged sword for cable vendors and programmers Pre-release demonstrations of the Media Server system have received rave reviews, and the technology alone is a major contender in the server wars -- right up there with competitive offerings from Silicon Graphics, Oracle, Hewlett-Packard and the rest of the pack. This presents the classic double- edged sword for Microsoft's potential customers in the cable community. On the positive side, Media Server is based on Windows NT, an existing operating system, which wedges Microsoft's foot in the door with the momentum of a very large and successful development community behind it. That means lots of good tools are in place to build interactive applications, and the likelihood of getting programming quickly onto a network -- thus the potential for a network's success -- is vastly increased. This is a powerful selling point to cable suppliers whose biggest nightmare is throwing a party to which no one comes: providing an expensive infrastructure upgrade to support interactive TV, then having no compelling programming to interact with. In fact, some believe that Microsoft's purchase of Softimage, the Canadian computer graphics tools company, is directly related to this effort. Like Microsoft Office, which is a collection of productivity applications, Softimage contains something called "Digital Studio" -- a collection of advanced multimedia and digital video (read: interactive TV) production tools for high-powered UNIX workstations. Peter Neupert of Microsoft's Advanced Consumer Technologies group says Microsoft will migrate Softimage tools to the PC desktop within five years. The flip side, of course, is that once such a system is in place, with all the benefits outlined above, Microsoft will be in a position to dictate the technical direction of network, or at least the interactive part of it. Some fear that Microsoft will then also take over the interactive media programming/applications market, as it did in PC software, because its internal content producers will have early and better access to new versions of Media Server's Windows NT system software and tools than will outside developers. (Microsoft consistently insists an internal Chinese wall between the operating system and applications divisions does not allow this to happen; developers consistently make claims to the contrary.) Is network administration worth a percentage of revenues? Caveats aside, it's an intriguing idea to let Microsoft manage the messy details of setting up and maintaining a complex and sophisticated interactive media network. But some cable operators wonder if letting Microsoft manage certain transactions is worth any percentage, no matter how small, of their company's revenue stream for interactive products. Not surprisingly, they say they'd prefer to pay a flat fee for the technology, and zero percent of revenues. In addition, despite the fact that some providers believe Microsoft's technology would beat the competition under any circumstances, others are concerned that Microsoft's leverage is so comprehensive that it locks out competition anywhere in the chain, and precludes an assessment of a fair market price for the value that Microsoft adds. One content provider calls it a "Trojan horse operating system" because not only could Media Server provide special advantages to Microsoft's own developers, but it also provides revenue to Microsoft all the way up and down its existing product offerings of operating systems, tools and developer support. But interactive TV will clearly take many years longer to implement than all the cable-telco couplings and decouplings of the recent past would indicate. And those who are interested in seeing where Microsoft might create recurring revenue streams have a lot more near-term worries than its Media Server. The long reach of Microsoft Network On November 14th of last year, at Comdex in Las Vegas, Microsoft finally announced its long-awaited entry into the commercial online services market. The announcement followed on the heels of two other significant -- and in retrospect, closely related -- Microsoft partnerships/ventures in the previous month: the stunning announcement of its merger agreement with Intuit, a highly regarded personal finances software company, and a letter of intent signed with credit card giant Visa International to provide secure transaction software for electronic commerse. Together these three announcements are graphic evidence of Microsoft's march toward the Holy Grail of the recurring revenue stream. What competitors most fear about the commercial online service formerly known as Marvel -- now named Microsoft Network -- is both its connection to a user base of potentially staggering proportions and its unprecedented convenience. Unlike America Online, Prodigy and CompuServe, which require users to load and configure a separate piece of software, Microsoft Network is part of the user interface for Windows 95: its icon appears automatically on every user's PC screen, requiring no setup or additional installation of software. Also unlike other commercial services, more than XX million of today's Windows users are candidates for an upgrade to Windows 95, putting Microsoft Network one mouse-click away from a subscriber base that's XXX percent larger than today's most successful online service. In addition, it is being designed to use standard Windows development tools (including some that will author "pages" for the Internet's WorldWide Web) to give content providers maximum flexibility over how their online areas look and perform. Again, this is a major improvement over today's commercial services, most of which require far too much handholding and which provide woefully inadequate tools for creation and maintenance of these areas. In addition, Microsoft Network plans to be global -- in 35 countries -- from inception, and has already enlisted four global telecom providers for infrastructure. (CompuServe is the only other commercial service with anywhere near this reach, and although it's certainly the granddaddy of online services, it's widely perceived as playing catch-up in the ease-of-use category.) It is also likely to offer fee-based access to Internet via built-in "sockets," or built-in network connections, via either alongside or as part of Microsoft Network -- either using standard phone lines or cable modems. But Microsoft's strongest selling point is a new revenue model for content providers. It says that instead of taking as much as 85 percent off the top of each content provider's gross revenues -- the standard (and outrageous) amount that AOL charges, for example -- the company says it will allow providers to employ variable pricing models such as subscriptions, online transactions, advertising subsidies and ticketed events and keep a much larger chunk of the revenues. Those who've heard Microsoft's pitch say the company will charge users a monthly fee of $4.95 for three hours of access anywhere on the service, including the information and entertainment services it develops in-house (and much online content is under development inside the company), and any time beyond that will cost $2.45 an hour. All usage revenue goes directly to Microsoft. Outside content or service providers (such as media companies) will be able to charge users and advertisers separately for subscriptions and ads, just like in the print world, and will be able to conduct financial transactions from within their areas (using the Visa/Microsoft-developed encryption technology, no doubt). For this, they will give Microsoft 30 percent of the subscription revenue they generate, 20 percent of each transaction and 10 percent of advertising . This sounds like a fabulous, and much improved, deal over what content providers get today from AOL, for example. But one online expert says when you start modeling these numbers, "it gets real interesting." How so? Well, she says, if the network isn't used much, then everything is peachy. However, if the network is an enormous success, Microsoft's take could grow much faster than its content providers'. For example, AOL members get access to all forums as part of their monthly service charge (which is $9.95 per month for the first five hours, $2.95 after). To date, no extra subscription fees are charged for access to the hundreds of magazines, information services and other forums that are part of the service. Today, content providers pay the lion's share of their revenues to AOL, but these revenues are based in large part on how much time users spend inside their areas. Thus if their area is particularly popular, their revenues are correspondingly higher based on the number of minutes spent in the area (though make no mistake about it, content providers on AOL today only make money profits on the bounties they get by signing up new members, not on hourly markups). Microsoft Network charges considerably less and allows content providers to keep the lion's share of the monies they collect from users. When the service first goes online, then, content providers who are able to sell subscriptions and/or advertising, or who include transactions as part of their service, will be getting a great deal. However, the more the network is used, the more money Microsoft gets -- while content providers keep only a fixed percentage of their fixed charges, even though they may be using far more resources to maintain a popular area. From the users' viewpoint, the low hourly rate is also great -- that is, until they start toting up the cost of subscriptions or services which are free on other commercial services today. If you subscribed to three magazines online at $5 each per month, for example, and spent three hours with each (and if the usage charges we're using are correct), you'd pay $33.65 per month on Microsoft Network. On AOL, you'd simply pay the $21.75 that you'd pay under any circumstances, and still have the ability to browse and sample from hundreds of forums. If online magazine subscribers are anything like print subscribers, and if online transactions are truly easy, people will sign up for new ones like crazy for the first few months; but it won't take many months of not having time to read a publication online before they start canceling their subscriptions. However, they'll still get Microsoft-generated content for the basic cost of access, a fact which may be driven home too late for third-party content providers. The Intuit merger is the most visible of Microsoft's plans for robust Microsoft-branded business and home office services on the network; a great deal more work is being done very quietly in Redmond to ready MSN entertainment services as well. Thus once again, just as in the PC business and the interactive TV business, Microsoft has placed itself in competition with its partners customers. With Microsoft Everywhere, not even the Internet is sacred MSN's most glaring weakness at this point is that its launch is tied to the release of Windows 95, which after slipping its release date many times over the past 12 months is already more than a year late. (In fact, as recently as August, the company expected to ship Windows 95 in 1Q95.) But once successfully launched, Microsoft Network might not only take excellent advantage of Microsoft's place in the PC market -- a daunting enough picture on its own -- but could also strengthen Microsoft's credibility in the media server/interactive TV network management business. Then add in the energy management system -- designed by Microsoft, TCI (which also owns 20 percent of Microsoft Network) and Pacific Bell -- that allows homeowners to set up a command and control center for home appliances such as dishwashers using a Microsoft-equipped hardware module and a Media Server-supported cable connection. Certainly Microsoft and TCI could siphon off a few dollars per customer per month on such a system -- which in an unusual turn of events for an interactive service, might actually save consumers some money. Telephones, too, could be connected to the Media Server so that consumers could be charged a few cents per each sophisticated "smart phone" transaction enabled by, say, smart phones (now being built by Telechips for a trial with U.S. West) equipped with Microsoft software. ACT's Mundie has already announced the Media Server is being designed to handle video messaging, videophones or videoconferencing -- clearly a recurring-revenue service similar to telephony services today. The commercial version of this capability, called TAPI for Telephony Application Program Interface and widely considered to be Microsoft's answering volley to General Magic's Telescript, is under development (but already significantly behind schedule). With its operating system attached to virtually every wire and device in the home and the office, the end result is Microsoft Everywhere, collecting a little bit of money from every activity consumers and workers engage in over the network -- maybe even to the point of colonizing the Internet. Mitch Kapor, PC software veteran and co-founder of the Electronic Frontier Foundation, thinks one strategic possibility is for Microsoft to incorporate the Internet as one part the ubiquitous network detailed above. By making two- way Internet connectivity part of this much larger Microsoft offering (which includes features and capabilities that run only in Microsoft environments), says Kapor, such a strategy uses the Internet's popularity and momentum to draw new users into Microsoft's own network. Unless the Internet is able to continue the past year's rapid development of new features, such as real-time voice and multimedia capabilities, Microsoft's embrace "would in effect cap the power and growth of the Internet and make it a sort of Central Park in Manhattan," he says. Breathtaking ambition in a shifting business environment This ambitious strategy is quite a departure for Microsoft, which has been content until now to collect its money in more traditional ways. But even though Microsoft has a viable technology for the market, it clearly is feeling its way on the business side just like everyone else. One Microsoft insider says bluntly of today's business models that "they're all broken." That's why virtually all the interactive TV-deals that have been made to date -- with Microsoft or its competitors -- are very hang-loose, option-based, non-exclusive letters of intent. This is certainly true of Microsoft's recently announced deal with Sony Corp. for settop boxes; as one Microsoft insider said, "you'd be hard pressed to find a fact in that announcement"; if anybody gets spooked about anything, including the intentions of their partners, they can back out of the deal, no questions asked. So even though fear, uncertainty and doubt usually work in favor of the incumbent, today it seems that Microsoft's far-reaching strategy might work against it. No one wants to take the risk of being married to one system so early in the game, especially if the system has the potential of locking out future choices by controlling the technical direction of global networks. As one cable provider said, "You have to be careful -- you're buying into an annuity that will never end." The question is, ŒDo you want it soon, or do you want it open?' Of course, the question that network providers have to honestly ask themselves is, "Do you want it soon, or do you want it open?" The adoption of any new media has traditionally required one company to control enough of the pieces -- especially the distribution medium -- to drive it into the mass market. A good example is the film business, which in its early days was owned in its entirety by Hollywood studios. The studio owned everything from the film to the theaters it was shown in. After a few decades, the government decided that the system was unfair to independent producers and forced studios to divest their holdings in theaters. But by then, the business of cinema was well established. Thus the nascent interactive media network scenario today is not a happy one for entrepreneurs, who have far too little influence to enter the fray, or civil libertarians, who see data networks as a new publishing medium that must be subject to the same free speech, common carriage protections as today's TV and radio networks and print publishers. But the alternative requires a great deal more patience and willingness to cooperate than anyone caught in the digital vortex seems willing to expend. Many organizations, including some of the people studying National Information Infrastructure (NII) initiatives for the U.S. government, would prefer to see a group of interested companies sit down and hash out a set of "open platform" standards for connecting to and providing programming for an interactive, broadband network, rather than allow a single company or even two or three control access. Though this is a terrific idea in theory, it's likely that hell will freeze over before it happens. Some serious issues to face before critical mass is achieved The bottom line for Microsoft is that it will have to face down some very serious issues before it can succeed in getting any critical mass for its Media Server and even for its more sure-fire offerings such as Microsoft Network. First, it will have to prove that it can be a good corporate partner. The company's reputation as a ruthless competitor is a very real detriment now that it must work with others to make a system succeed. Put in a shark sentence about TCI -- two sharks swimming in thes ame tank, respecting each otheršs teeth. Cultivating these relationships might be less difficult to negotiate if Microsoft weren't already in competition with its potential partners. So not only does it have to prove that its technology, which has a less than stellar reputation to date for reliability and time to market, is indeed a solid distribution and creation platform, but it must also prove that it will neither appropriate ideas from its customers for its own publishing enterprises, nor give precedence to its own products on the network. As mentioned earlier, this is a historical problem for Microsoft as an operating system and application provider, and it's not one that's likely to go away no matter how much the company denies it. that it's a problem. Media companies will be far more vocally aggrieved by any perceived wrongdoing on Microsoft's part, and without the willing partnership of media companies, both Microsoft's Network and Media Server businesses become unremarkable overnight. Second, the company will have to be a bit more realistic and forthcoming about whether all these great new products will work, and when. Despite terrific descriptions and demonstrations, virtually none of Microsoft's most promising technologies are complete enough to judge how they will perform. It can't even get its flagship operating system products, upon which its entire strategy rests, out the door in time. Microsoft's legendary pre-announcement of products, combined with its inability to predict even within a year when they'll ship, is already being met with a lot less indulgence when publishers are relying on its network technology to distribute their products and services. And last, there is a very real risk that Microsoft has bitten off more than it can chew. A quick browse through the last few months of computer trade magazines reveal that even Microsoft's corporate customers, tolerant in the extreme, are confused by the sheer amount and complexity of work being done on industrial-strength operating systems. Microsoft's cultish employees, who for years have formed a flying wedge behind Gates, are starting to worry as well. As one said, "It's a simple matter of bandwidth. Everyone knows that it's Bill, and to some lesser extent (Steve) Ballmer (executive VP of sales and support, widely known as Bill's closest confidante), who are running the place -- everyone else is just an extension of their ability to get things done. And communication is breaking down." The result of increasingly limited bandwidth at the top of the company can be seen in sloppy product releases such as Word 6.0 for the Macintosh, and as mentioned above, in the continuing slippage of ship dates for key products such as Windows 95. There is clearly a limit to how much Microsoft or any company can take on without imploding, but it's a very difficult situation to turn around: Microsoft's continuing success is a direct result of Bill Gates' brilliance as both a technology visionary and a business leader. Many believe that Microsoft will be forced by the laws of physics to scale down its ambitions. It's hard to surf a riptide under the best of conditions, and it's probably impossible from the deck of a barge. And despite the fact that it has oodles of money and ambition, Microsoft is not a surfboard anymore, and it simply doesn't ride like one. Navigating the stormy seas of leverage v. conflict of interest Bill Gates delivered the keynote speech at Comdex last year, the same Comdex where his company announced the Microsoft Network. During his presentation, he tried to downplay the power his company has amassed over the years. "If you go back and look at last calendar year's sales, you'd find that Microsoft is the twentieth largest company in this industry. A lot of people get up and say how big their company is," he said. "What I'm trying to tell you is how small our company is. We're just a piece of the hardware business, the service business, and we have decided to focus on only one aspect, and that is building software products." That may be technically true, but it's incredibly disingenous in a business environment where software has become the coin of the realm ‹ it is the means by which digital media is created and distributed, and it is media itself. In such an atmosphere, the influence of the world's largest software company resonates far beyond its market cap revenues. A little as a year ago, when the focus was on cable-telco partnerships and interactive TV, Microsoft was selling potential, not product. But since the spike in popularity of the home PC, CD-ROM and online services, the focus has clearly shifted away from the TV and back onto the computer, Microsoft's home turf. Its influence has inflated accordingly. With this in mind, some very serious questions are now rightly being raised about Microsoft's role in the digital age. The most obvious, of course, is whether success has given the company too much power. But the question itself is overly simplistic, and lends itself too quickly to scornful remarks about sour-grapes competitors. It doesn't take into account the complex new control mechanisms and interdependencies that are created as global economies and industries move commerce onto digital networks. Industries that are now forced to consider partnering with Microsoft because of its clout in the PC industry -- a list which to date includes print publishing, music, film, cable and telco companies and financial services -- know from history they are risking indentured servitude by partnering with the software giant. But what choice do they have? Microsoft controls the predominant PC platform and its network extensions; it owns authoring tools, dominates productivity applications, and will control the digital cash and transaction software for what will likely become the largest online service in the world; it already runs one of the most successful interactive media publishing entities in the industry, and is implementing a business model that allows it to collect a percentage of all transactions, subscriptions and advertising revenues from other publishers that want access to its huge customer base. And whatever Microsoft doesn't want to compete with, it can (and often does) buy. When delivering a digital media product on a computer platform, choosing to go with a Microsoft competitor means taking a huge gamble on even being able to find the market, let alone potential customers. Thus the larger question -- and one which to date has received scant consideration -- is whether there is something organically different about doing business in a digital environment that makes the term "conflict of interest" more applicable than what's commonly thought of today as "leveraging assets." Given its massive holdings and far-reaching strategy, is it even possible to compete with Microsoft on its own turf? Too many companies would say no. When software becomes as ubiquitous and indispensible as it is in today's economy, it may be time to question the prudence of letting any single company direct so much of its future.