Microsoft feels the heat of the digital threat

Microsoft feels the heat of the digital threat

Updated29 Jan 2007

Running a storied enterprise like Microsoft -- software heavyweight, geyser of cash, corporate icon -- is about much more than energy and commitment, says Steven A. Ballmer, the company's chief executive. It is all but a calling, an article of faith.

"You've got to be very realistic about where you are, but very optimistic about where you can be," he said during interviews this month. "And the day you can't be both of those things, you shouldn't be a leader of a company like Microsoft. You have to believe; you have to believe; you have to believe."In the Ballmerian world view, failure is not an option. "If we don't get it right at first, we'll just keep coming and coming and coming and coming," he says.

For the better part of the last two decades, the prospect of Microsoft coming and coming and coming, relentlessly picking off and then dominating various sectors of the software business, has sent shivers through the ranks of its competitors. Many have fallen by the wayside or changed course to avoid being crushed by one of the most successful and viciously competitive companies of any era.

No longer.Competitors once feared and respected Microsoft. Now they simply respect it. And as Microsoft prepares to unveil new versions of its desktop operating system and office programmes it finds itself facing emboldened competition, even uncertainty. With the Internet revolution upending business models across a broad swath of industries, Microsoft itself is feeling the heat. The challenges that the company confronts today are different from those of the past, and its market power in the personal computer business matters less than before.

More homes and offices are being wired with high-speed Internet connections, a market-altering shift that is buttressed by a stream of advances in data storage, computer-processing and software. This second generation of Internet technology animates advertising-supported Web services like search, and opens the door to the delivery of online alternatives to Microsoft's popular desktop programs like e-mail, word processors and spreadsheets.

The consumer rollout of new models of Microsoft's mainstay products, Windows and Office, is one that many industry analysts view as the last hurrah of the fading order of computing, dominated by the PC and ruled by Microsoft.Google, the search giant, is, of course, the leader of the Web 2.0 wave and may be the most potent competitor Microsoft has ever encountered. But Microsoft faces a variety of nimble, wily and innovative opponents in other markets as well. In video games, it goes up against Sony and Nintendo; in music players, Apple; in corporate software, IBM, Oracle and Linux.

Deciding how to respond to Microsoft's growing host of competitors has fallen to a bullet-domed, hulking, boisterous whirlwind whose friendship with Bill Gates, Microsoft's founder and chairman, dates back to their college days and whose dexterity and acumen will determine Microsoft's fate. Gates declared last June that he plans to step out of day-to-day work at Microsoft entirely by the middle of next year to become a full-time philanthropist.Gates says he is confident that he is leaving Microsoft in safe hands. In an e-mail message, he calls Ballmer "a great partner and a great friend" and describes his relationship with Ballmer as "one of the greatest business partnerships of all time."Yet earlier victories may not help Microsoft much today.

"The world has changed, and how Microsoft adapts to that change is going to be the test of Steve Ballmer," observed Brad Silverberg, a venture capitalist and former senior Microsoft executive. "He has fundamentally sound judgment, he's a great leader and he's capable of listening and hearing things that are not the way he wished. He has the tools."Others who have worked with Ballmer over the years have no doubts about his intelligence, persistence and underlying pragmatism. Even so, Microsoft, despite its deep pockets and immense resources -- in fact, precisely because of those vast resources -- has potentially much more to lose in the Internet age than other companies."This is every bit as disruptive for Microsoft as it is for others," said George F. Colony, the chief executive of Forrester Research, the technology consulting firm. "The dilemma for Microsoft is that it is a prisoner of its business model, and the fact that it is a gilt-lined prison makes it brutally hard to change."

One of the evolutionary laws of business is that success breeds failure; the tactics and habits of earlier triumphs so often leave companies -- even the biggest, most profitable and most admired companies -- unable to adapt.Microsoft faces that quandary today. A huge promotional push will accompany the arrival of Microsoft's gold-mine offerings, Windows Vista and Office 2007, because the desktop operating systems and office software businesses accounted for a majority of Microsoft's $44.28 billion in revenue last year and about 80% of its profit. Yet Windows Vista, repeatedly delayed and arriving two years late, comes as the center of gravity in computing shifts increasingly toward the Internet.

The PC software business will not wither anytime soon, technology analysts and executives say, but more and more of the excitement and significant new applications will gravitate to Internet-based software. Since Ballmer's first full year as chief executive in 2001, Microsoft's revenue has risen 75 % and its operating profit 40 %, but its stock price has been flat, reflecting Wall Street's doubts about Microsoft's growth prospects.Yet as Ballmer navigates this pivotal juncture in his company's 31-year history, he remains a visceral optimist. (He often deploys a favorite Colin Powell quotation: "Persistent optimism is a force multiplier.")

When asked about his biggest worry for Microsoft's future, he dismisses the notion of worry as "a funny term," as if it were an alien concept. Instead, he speaks of advertising-supported Internet software and services like Google and open-source software like the Linux operating system as "new business models that we either have to compete with or embrace" -- and thus rivals worthy of his attention and his "spare brain cycles."Don't call it worry, but Ballmer acknowledges that Microsoft's toughest task has been in deciding where to place its bets in new markets or technologies that do not operate by the same rules as its tried-and-true products. "One of the biggest mistakes I've made over time," he acknowledges, "is not wanting to nurture innovations where I either didn't get the business model or we didn't have it.

But those days are past, Ballmer declares, saying he and Microsoft have learned their lessons. He pointed to Microsoft's Xbox video game console, its Zune music player, Internet search and online advertising as examples of big investments the company is making in businesses that are very different from its lucrative stronghold in PC software."I think we've shown more willingness to embrace new models than anyone else in the technology business," he asserts. "Will it be good enough? Let's see."

The prevailing image of Ballmer, 50, is mainly that of a marketing dynamo, a hyperkinetic, booming orator who can fire up the sales staff and industry partners to labor tirelessly on Microsoft's behalf. He has strained his vocal cords when shouting at sales meetings. Years ago, his gestures became so animated in a meeting with reporters that he cut himself in the face with a fingernail and, bleeding, continued on, extolling the virtues of the latest Microsoft offering.Videos on the Web show Ballmer at large Microsoft gatherings several years ago, when he was heavier, bounding across the stage, mostly screaming. In one, he finally comes to the lectern to shout to the audience, "I have four words for you: I love this company."People typically have one of two reactions when they witness this behavior: either, "This is a man whose stability is in doubt," or, "This guy is no corporate politician; he really believes."

Trailing Ballmer this month, at a pair of speeches and small meetings with industry groups and customers, suggests that his performances have become more subtle. Speaking to several hundred people at the annual convention of the National Retail Federation in New York (one of about 120 such speeches he gives a year) he orates without notes or a teleprompter and paces the stage, rarely standing still for more than a couple of seconds.He tells the retailers of the two years he spent as an assistant product manager at Procter & Gamble, after graduating from Harvard, before attending Stanford business school, until his old Harvard classmate, Gates, persuaded him to join Microsoft in 1980.

Ballmer gives the retailers a glimpse of how consumers will increasingly use technology to search, compare prices and shop. He tells them, "Our company is committed to retail, and invested in your success." During a question-and-answer period, he says the "heart and soul" of connecting to the Internet, either by cell phone or PC, is "likely to be a Microsoft operating system running a Microsoft browser." The unstated, but clear, message is this: stick with Microsoft, the safe choice.

On the floor of the Jacob K. Javits Convention Center, Michael Mauerer was pinning his start-up company's success to Microsoft technology. His company, Retail Teamwork, is building software to automate the purchasing, sales and store operations of small to midsize retailers. His product is being built on the Microsoft's business applications software, a market that Microsoft entered in the last few years. "Microsoft is a very safe bet," Mauerer said. "They've never failed. They ultimately get it right."

Before and after the morning speech to retailers, Ballmer holds a dozen small meetings with senior managers from retailers including Wal-Mart, Circuit City, Safeway and Crate & Barrel. The next morning, after a five-mile run in Central Park, Ballmer has an 8 a.m. meeting with about two dozen corporate customers, mostly from Wall Street and commercial banks. In front of this smaller group of sophisticated information technology managers, Ballmer gives a very different talk and fields more detailed questions. The topics run from the intricacies of licensing data-center software to Microsoft's stance toward free software like Linux.

At one point, he says, "All software will become software with a service." Ballmer emphasizes the word "with." The clear message is that Microsoft is embracing the move toward software written by using open Web standards and delivered over the Internet, but that these software services will be added to Microsoft products instead of replacing them. We will move to the new world, he suggests, but will not cannibalize our flagship products.

Yet Kuss recalled that what impressed him most was when Ballmer said his proudest achievement was shaving 20 seconds off his time running the quarter-mile. Even then, his time wasn't good, and his main event in track was the shot put. To his former teacher, Ballmer's remark years ago speaks of persistence and character. "The things that he was good at and came easily to him, like math and science, he enjoyed," Kuss observed. "But the things he had to struggle with were the things that gave him the most satisfaction."

So where, exactly, has Microsoft been expansive? Ballmer and others at the company point to Microsoft's video gaming business, led by its Xbox machines. Believing that software was playing an increasing role in consumer electronics, and that Internet-connected video machines looked to be a vital on-ramp for delivering technology to homes, the company decided at a meeting on Valentine's Day 2000 to take a leap into video gaming, shortly after Ballmer became chief executive.The meeting, in the Microsoft boardroom on the corporate campus in Redmond, Wash., was scheduled for an hour, but it lasted more than three hours. A handful of executives attended, including Gates, Ballmer and Bach, who now leads the Xbox and Zune units.

"The real discussion came down to some very hard choices about Microsoft deciding to do something that was really not our normal model," Bach recalls. A video game console is tailored for playing games, unlike a personal computer, which is a general-purpose system. The Xbox would run its own software. "It's not Windows," Bach says, "and we don't pretend it's Windows" -- a notion that was heretical inside Microsoft at the time Xbox was first concocted.Ballmer, according to an account by Bach, told the participants at the meeting that they would not leave the room until a decision was made. When agreement was reached, Ballmer told Bach and J Allard, the leader of the Xbox development team: "I won't be second-guessing you every third month. I trust this team; go get it done," as Bach recalled.

The Xbox shipped in November 2001 and struggled at first, as gamers flinched at its $299 price. Within months, Microsoft cut the price by $100, and sales picked up; it eventually sold more than 24 million consoles. The next-generation Xbox 360, equipped for online gaming, arrived in the fall of 2005, beating Sony's PlayStation 3 to market by a year. More than 10.5 million Xbox 360 consoles have been sold, and half of the buyers subscribe to Xbox Live, an online gaming service.

Still, despite investing billions of dollars, Microsoft has yet to show any profit from its video game venture. "Look, the jury is still out," Ballmer acknowledges. "But I feel very confident that we've built a good market position with Xbox. I feel very confident that we're on track to make money." The company has said the Xbox business, including hardware and software, should move into the black this year, but when, and if, the business will pay back its multibillion-dollar investment is unclear.

And Zune, introduced late last year, is just beginning a long and costly uphill fight against Apple's iPod business in the digital music market. "No other company, for better or worse, would be willing to get into that business at this time," Ballmer says.

The new product lines are Ballmer's answer to the most nettlesome questions about Microsoft's future: Where will it find new growth as the Windows and Office businesses continue to mature? Can Microsoft navigate its way to a future that is as bright as its past?

The challenge comes amid a leadership transition at for Microsoft, as Gates prepares to stop working daily at Microsoft by mid-2008, though he will remain the board chairman and the largest shareholder. Ballmer and Gates have shared one of the most enduring and lucrative partnerships in American business over the years. Put simply, Gates has served as the main architect and master strategist at Microsoft, while Ballmer has served more as the tactical field marshal.

From the outset, Gates recalls in his e-mail message, "it was clear to me that Steve's skills would be absolutely essential to our success." Though their talents and personalities are different, Gates said, "we have a common view at the highest level of what the company needs to do to succeed: hire great people, make big bets and take the long view and be patient where we think there are the greatest opportunities."

Ballmer has been the company's chief executive since 2000. But on the day Gates announced his plans to spend more time on philanthropy, Ballmer recalled, he felt as if he was entering a "new era" personally and that he had a "new job."

If Ballmer has entered a new era personally, some things still have not changed. Not long ago, after finishing off a conversation with an aide, he backed up quickly and banged into a reporter, sending him reeling. With a helping hand and grin, Ballmer joked: "So much for the kinder, gentler Ballmer. He's still knocking people down."

To the degree that a kinder, gentler Ballmer -- and Microsoft -- truly exist today, it is largely a legacy of the antitrust rulings against the company in the United States and Europe. A series of federal court rulings in America several years ago found Microsoft to have repeatedly bullied rivals and industry partners to illegally thwart competition. Until the court setbacks, Ballmer, like Gates, dismissed any suggestion that Microsoft had done anything wrong. Their view was that the suits against their company were the handiwork of disgruntled competitors lobbying antitrust regulators.

But once Microsoft lost, it became Ballmer's job to settle its legal troubles and repair the damage to the company's reputation. He appointed a new general counsel, Bradford L. Smith, and directed him to talk to and cooperate with people previously regarded as Microsoft enemies: government officials and competitors.

Smith says his job has been made easier by Ballmer's willingness to meet people on their own turf. For example, Ballmer opened settlement talks over a round of golf in California with Scott G. McNealy, Sun Microsystems' chairman, and addressed the French Senate in fluent French. (Ballmer spent two years in elementary school in Brussels.) An antitrust dispute remains with Europe. But Microsoft has settled state and federal lawsuits in America while paying more than $4 billion in private settlements related to the federal case.

Ballmer and other Microsoft executives often scorn online alternatives to its desktop software as second-class options with no market. Internet-based software, they say, lacks the features and functions of Microsoft's "rich client" programs. Also, what happens when computer users are not connected to the Internet, say, on an airplane?

That's wishful thinking on Microsoft's part, say the Internet insurgents from Google and elsewhere. They say Microsoft's critiques attack older, browser-only programs instead of newer software services that place some applications on PCs while also linking the machines over the Web to supercomputing data centers. New features and services, they say, can flow to users every time they tap in, instead of waiting three years for the next version of Office. The classic work-on-a-plane problem? Researchers, they add, are working on caching software and other innovations to solve those kinds of problems.

Eric Schmidt, Google's chief executive, discussed the implications of this "emergent new software applications architecture" in a meeting with computer scientists in Washington last fall.

"So the obvious question becomes to what degree can this replace the traditional Windows-dominant, PC-dominant, monopoly structure that we've all been used to," Schmidt said. "It's pretty clear to me that there are enough people working on this in research universities and in companies, building applications that empower this, to make it happen."

Microsoft recognizes the threat. The company has top technical talent working on Internet services, and it has brought out offers like Office Live, a package of services to help small businesses set up Web sites. But some industry analysts say Microsoft is being too timid, fearful of cutting into its traditional PC software business."Microsoft is now focused and engaged, but we haven't seen much yet," said Richard G. Sherlund, an analyst at Goldman Sachs. "Where's Office delivered as a service? Where's the online versions of Excel, Word and Powerpoint?"Microsoft, Sherlund said, has to recognize that "there will probably be some cannibalization of Microsoft's existing business, but that's the price of customer acquisition going forward in Internet services.""And it could turn out to be a good business for Microsoft," he added, "if they can generate online traffic and make money with better search and advertising."Ballmer replies that there are different paths to putting more of Microsoft's offerings online as Internet services that rely on subscriptions or advertising to generate revenue. "I guarantee you that all of those options have been considered, and some are being pursued," he says, declining to elaborate.

To succeed, Microsoft must convince new recruits that it will be a leader as the next wave of computing unfolds, and not just a defender of the status quo. Microsoft has suffered a few high-level defections of senior technical people recently but has managed to lure some top talent as well.In 2005, Gary Flake left his post as the head of research at Yahoo to join Microsoft, where he set up Live Labs, the company's Internet research unit. Until Microsoft wooed him in earnest, Flake, 39, said he had not considered working for the company. He was a product of Silicon Valley's technology culture, and he said he had been recruited by Google and saw Microsoft as the old-line enemy.But Flake decided to join Microsoft after, he says, he came away "stunned at how open the company was to change, how self-critical the culture was.""Microsoft, more than the others, is redefining itself," he added. "And I do think Microsoft is in a position to raise the bar for what is possible in Internet services."

Embracing the Internet may be part of Ballmer's agenda, but he is still left with the chore of defending and milking Microsoft's huge cash cows, Windows and Office. When he talks about the Web, he accents the need for accelerated innovation.In the same breath that he emphasizes innovation, Ballmer describes his new strategy in the vernacular that Microsoft has been using for years: "embrace and extend" -- in other words, new products and services should simply be extensions of the old. Even if rivals and industry experts doubt that the old Microsoft game plan will work this time, Ballmer is certain that it will."We will do well," he told a group of investors and analysts at the company's headquarters last year. "Whether it's me or the guy who replaces me because we don't do well. We'll keep coming, and we will do well."

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