Services: A risky bet on MSN

By Joe Wilcox
Staff Writer, CNET News.com
October 16, 2002, 4:00 a.m. PT

Only a year ago, Microsoft and the rest of the high-tech industry were anticipating huge consumer demand for Web services ranging from shopping to communication. Then reality set in.

Originally code-named HailStorm, Microsoft's plan for delivering consumer Web services immediately ran into resistance because of security concerns and confusion. Microsoft made matters worse by publicly christening the program as .Net My Services, a name often mistaken for its broader .Net technology architecture.

Now, the company is building its consumer Web services around its MSN Internet access service--a move that poses yet another set of risks, given that the online property has been a money-losing operation for years. The decision will fall under intense scrutiny this month when Microsoft breaks out MSN revenue from other consumer products for the first time in the company's quarterly financial report.

"That puts a spotlight on MSN. Wall Street looks and sees that, again and again, all this thing does is lose money," said Rob Horwitz, an analyst with Directions on Microsoft. "It's time to figure out how to make this puppy profitable."

The gamble has ramifications well beyond MSN. The move represents an important change in strategy for Microsoft, which had originally sought to provide the infrastructure needed for e-commerce sites and other consumer businesses to run Web services. Through HailStorm, for instance, Microsoft had planned to offer Web hosting and access to a rich database of customer spending habits.

But Microsoft realized it has relatively little experience as a hosted services provider, so it plans instead to refocus on what it does best: Sell software. "Nobody at Microsoft was able to clearly explain and plot out a timeline where the company would start making money from its services. Microsoft is a product company," Horwitz said.

The product, in this case, is MSN. By offering these new Web services almost exclusively through this venue, the software giant is taking a step backward in its Web services plans and betting that MSN subscribers will pay to use those services, even though the company has not figured out how to make the online network profitable so far.

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To some industry veterans, Microsoft's plan basically is trying to make a right out of two wrongs. But Paul-Jon McNealy, an analyst at Gartner, said the company is taking the right steps by adding potentially lucrative services to MSN. "If you look at how you build incremental revenue streams, you start with advertising and look at pieces people are interested in early on. That's music and games in the narrow- and broadband stuff, and movies down the road," he said.

In many ways, the strategy is classic Microsoft: Use existing software to leverage other products, just as the company has done for decades with its Windows operating system. The difference, of course, is that the market share for the MSN Internet service has nowhere near the overwhelming dominance of Windows; in fact, the network trails its main competitor, America Online, by millions of subscribers. Moreover, Microsoft faces growing competition from consumer-focused companies like AOL Time Warner and Yahoo that are offering services of their own.

Still, Microsoft has committed itself to the Web services crusade in its search for new business as growth in the PC market--and therefore Windows--continues to level off. And after the disappointing results of its earlier consumer service initiatives, the MSN plan seems to make as much sense as anything else.

"Overall, we're seeing the entire industry making a shift, where more companies are offering less for free and focusing more on the bottom line," MSN product manager Lisa Gurry said. "(We're) also focusing more on profitability than we have in the past."

A tale of two MSNs
Microsoft's plan will split MSN in two. For years, Microsoft offered those using the free MSN.com portal and those paying for the MSN Internet access service essentially the same content and Web services. Starting with the release of MSN 8, expected as early as October, Microsoft will separate what is offered through the Internet access service from the portal's options.

Rather than an a la carte menu of disparate paid services through MSN.com as earlier conceived, Microsoft will offer more focused services only to paying MSN 8 subscribers. Because those customers have already shown they are willing to pay for MSN's Internet access, Microsoft is targeting them as the most likely consumers of other online services. MSN 8 includes software from existing Microsoft products, such as Money or Picture It, that tie into additional Web services available for fees.

"The MSN.com portal will continue to deliver great content and services such as Hotmail and MSN Messenger," Gurry said. "But our focus on new technology innovations and services will be delivered primarily through our MSN 8 subscription service or future subscription services."

Microsoft is banking on some of those new technologies, such as spam filtering, to woo customers from America Online, Yahoo and even MSN.com to MSN 8. "The parental controls are a nice hook," McNealy noted.

Executives say the strategy will allow Microsoft to consolidate its Web services into more easily managed chunks. MSN 8 will offer three prices based on whether consumers bring their own access, use a standard dial-up account or have a fast broadband connection. The company could offer still more pricing options by adding services tailored to particular types of customers, such as students and home businesses.

Portal without a cause?
Shifting emphasis to paid subscribers might make sense for services, but Microsoft must also address how to continue capitalizing on the popularity of MSN.com and not just cannibalize its business to grow MSN 8's rolls. Microsoft claims that 300 million people use the Web portal each month compared with 8.7 million MSN Internet subscribers.

Part of MSN.com's growth comes from its placement as the preset home page for the majority of computers sold to consumers. The portal also gets traffic directed from other Microsoft products, such as Money, Office, Windows XP and Internet Explorer, which automatically send surfers to MSN Search for unrecognized domain names.

"Our surveys show year after year that almost 50 percent of consumers don't change their home page," said Jupiter Research analyst David Card. "If (MSN) didn't have the default home page, I'm sure their traffic would go down a bit, but they're a serious contender. They deliver a collection of services that people have found useful."

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"We have this sort of double-edged sword," MSN Chief Executive Yusuf Mehdi said at a recent meeting with financial analysts. "As we get more Hotmail users, the cost to run that service has risen. And if the online ad market doesn't keep pace, you are not able to make that profitable."

Microsoft has attempted to reduce costs through technical changes and the addition of premium paid services, such as more storage capacity for Hotmail. The software giant may also expand other portal services, such as the .Net Alerts service delivered through MSN Messenger and Windows Messenger.

Pointing to dollar signs
Recent figures show that Microsoft may be making some headway. Despite the weak ad market, the company reported that MSN revenue jumped 20 percent in fiscal 2002, which ended June 30, from the year before. The company's $595 million ad revenue was up $38 million from fiscal 2001.

Mehdi contrasted his group's performance against that of Yahoo, which saw dramatic declines in ad revenue last year. "Yahoo dropped just shy of $200 million in the last fiscal year, according to their numbers," he said at the financial meeting. "And we grew roughly $40 million in that year."

The AOL question
But Yahoo represents only part of what MSN is up against. Another part--challenging AOL's paid subscriptions--is far more important to its consumer services strategy.

"If you look at the amount of time people spend on the Internet, AOL is huge," Jupiter's Card said. "It's like 25, 26, 27 percent...which is monstrous. Its market share dominance is phenomenal."

Based on Microsoft estimates, AOL takes in about 30 percent of U.S. consumer Internet revenue versus about 5 percent for MSN. AOL also has more paying subscribers for its Internet access service, 35 million versus MSN's 8.7 million.

Yet even in that underdog status, Microsoft sees a potential for huge windfalls. By fiscal 2005, the company estimates that the consumer online services will present a $48.7 billion opportunity, fueled by advertising, digital marketing and Internet access revenues. Just increasing Internet revenue share to 10 percent would yield MSN nearly $5 billion in yearly sales, by Mehdi's estimates.

In addition, industry analysts believe that MSN is in a stronger position than its rivals to capitalize on the shift toward revenue from transactions rather than portal advertising and Internet access. That is partly because Microsoft benefits from a rapidly coalescing technology strategy that looks beyond advertising and Net subscriptions to new areas of business.

For example, analysts say, Microsoft is advancing its broadband service faster than its competitors and locking in transaction-based entertainment to deliver over those fatter pipes. Among those services are PressPlay for music, Intertainer for movies on demand and Xbox Live for games--all services tightly tied to MSN.com, MSN 8 or other Microsoft software, such as Windows Media Player 9 Series.

"Microsoft's a step ahead of both AOL and Yahoo on this one, even though AOL Time Warner has more content," Gartner's McNealy said. "Right now AOL is No. 1. Whether they remain No. 1 in two years remains to be seen."

Strategy: Microsoft vs. Microsoft