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Microsoft's new challenge to AOL

newsmaker MSN head Yusuf Mehdi will have his hands full trying to unseat America Online, but the exec says changes in technology and customer tastes will work to Microsoft's advantage.

Yusuf Mehdi is not one to shy away from a good fight.

As director of marketing for the Windows operating system in the early 1990s, Mehdi helped direct Microsoft's successful strategy against IBM's OS/2. A few years later, he found himself back in the thick of things, this time as marketing manager for Internet Explorer as Microsoft vanquished Netscape Communications in the slugfest over Internet browsers.

In both instances, Microsoft started from behind only to emerge with slam-dunk victories. These days, the 36-year-old Mehdi is hoping three's a charm as he heads up the company's MSN unit. But in taking on America Online, Microsoft faces a formidable foe with more than twice its share in the online services market.

Long the company's ugly stepchild, the MSN online service has undergone a handful of strategic shifts while losing loads of money. And with 9 million dial-up subscribers, MSN remains a distant second to AOL and its 35.3 million. But this month, Microsoft has launched an upgrade that Mehdi believes will win over the hearts and wallets of Internet consumers.

Mehdi spoke with CNET News.com about the upgrade and his plans for MSN, while also offering a rare peek into the unit's audience and its financial numbers.

Q: You're doing a lot of catch-up to AOL with the new parental controls and spam filters. Are you still trying to create MSN under the image of AOL?
A: No, I think the MSN 8 release is a watershed release for a number of reasons. One of them is the new business we're headed with, with BYOA (bring your own access), and the future of Microsoft, with MSN services and subscription. The other part is that the end-user offering is for the first time better--hands down, across-the-board better--than AOL on all fronts. I think last year with MSN 7 we were better for some people, we weren't as good for some people. Parental controls--we didn't have that last year. But I think we did them one better this year.

You're still really far behind AOL in subscribers. How can you convince people to use your product versus their product?
People say there's all these people on AOL. But does that really matter to you as a user? It doesn't matter to anyone unless you're an AOL user, and if you're an AOL user, the thing you miss is your buddies. That's why people say: "Well, do I want to leave for this better service? Yeah, but I'm afraid to lose my buddies." One of the best-kept secrets on the Internet today is you can use the AIM client for free. So you can leave AOL and keep all your buddies and actually use the AIM client with the MSN service.

Microsoft has taken many years to get to 9 million subscribers. Still, you're at a third of AOL's U.S. audience. What do you attribute your slow growth to?
That's all true. We did have a bunch of strategy changes in the past, and this is probably over four years now. You're right, the strategy changes got us off to a slow start...MSN's share is now 10 percent of the ISP (Internet service provider) market, whereas before we were 5 percent, and AOL's still roughly 30 percent of the market. So when you look at the share of the market, we've grown radically. I mean we're the only ones who've grown.

The strategy changes got us off to a slow start.
But isn't that slicing hairs in terms of how you count subscribers? What part of the 9 million do you get from Web-based services like extra storage on Hotmail versus strictly ISP subscribers?
We've never been about access at the end. AOL is really all about the access game, and narrowband in particular. We have been about delivering premium subscription services, so to us it is actually more meaningful that someone signs up for MSN extra storage.

As you move to broadband, which is the wave of the future, all these customers that AOL has on narrowband, as well as ours, they're up for grabs. What really matters is, when you get to broadband, who has the relationship with the customer? That's why these relationships that we have today, I think, are more valuable because they play better in the broadband world.

But at the same time, we're trying to get an apples-to-apples comparison. AOL broke out last quarter that 17.7 million customers in the U.S. are paying top-dollar, $23.90 a month. How many people are paying $21.95 a month for MSN?
One, we don't report it out. And two, the reason why we put them all together is that all the relationships are more interesting than just the ISP relationship. The other part is that some of that is looking back in history. I don't dispute that they built a big base of users paying them a lot of money. They did that because they were out first and they stuck to a strategy. I say kudos to them. The way I'm looking at it is, I'm looking forward, not backward.

Some people dispute your numbers as well.
That's fine--they can dispute them. As I look forward, the point I'm making is that our growth, according to these analysts, is that we're 10 percent of the market in terms of subscribers. And as we move forward, we have a better product and a better price, and I think this will be something that will grow for us.

Can you say what percentage of your customers are broadband customers?
We're not breaking it out. We have one number for competitive reasons.

AOL's profit margins are coming from people who are paying for dial-up, which means AOL is deathly vulnerable to broadband. The question is, how well are you doing in the area? You've given us no number or told us anything. So tell us something.
Here's some rough numbers on economics. Every narrowband customer for AOL or for any other ISP today probably generates about $10 worth of profit (each month). AOL may be making a little bit more per customer, so they're making $120 a year on profit. When they move to broadband--if they move to anyone but Time Warner Cable--all that is gone. I can tell you just from what we're paying for tariff rates.

We're all in the same boat, where the move to broadband is a challenge. Where you can do better is if you have a deeper deal with an ILEC (incumbent local exchange carrier), like what we have with Qwest and Verizon. And in that deal, without giving you the economics, we can actually go to market with those two folks profitably and acquire subscribers. That's something AOL cannot say at all on DSL. They can say it on Time Warner, but I bet if you do any research, you'll know the most successful ISP on Time Warner is (Time Warner's own) Road Runner.

We're all in the same boat where the move to broadband is a challenge.
So you're saying your arrangement with Verizon and Yahoo's arrangement with SBC Communications are an advantage?
Huge. So 50 percent of the DSL market we can go after and grow. So you ask a fair question, of how've you done. Two things--one, we've only been in the market with Qwest. We just got off the ground with our DSL nationwide offering. Verizon, which is going to come out with MSN 8 in the spring, is going to be a huge boost. Once you get Verizon out for a few months, that's when you're going to see some amazing numbers. I can tell you this--among all the people who have done well on broadband DSL today, we're right with any of those guys.

AOL's experiencing right now what Yahoo has been going through for the past two years. Both companies one day all of a sudden realized half their advertising is gone. You recently reported $427 million in revenue last quarter for MSN. You didn't break out where that money's coming from. How much of that is online advertising revenue, and do you have fears that online advertising is also going to pull from underneath you guys?
The $427 million that we reported in the quarter was total revenue. We didn't break that out. But the number I can give you is that the last fiscal year we did roughly $557 million of advertising and e-commerce revenue for the year. Basically, we're just under Yahoo for advertising and e-commerce. So we are a big-time business.

Last year we grew our revenue $40 million, and Yahoo lost $200 million, and AOL lost half a billion (dollars). So we grew $40 million in ad revenue last year. This year, what we did say in our financial earnings announcement is (that) we grew quarter-over-quarter ad revenues of 40 percent. So we are on a monster roll on the ad business.

How is that possible? The online advertising business has been completely depleted.
Let me explain that. This is the best-kept secret in the industry, which is that the online ad business is alive and well and actually kicking butt for a number of companies out there. The reason why it's masked is that when people go and cite the overall ad number, they basically are rolling up one big monster guy who did a ton of terrible deals and has dropped their revenue forecast from $2.7 billion a year ago to now a forecast of $1.46 billion. So they dropped their revenue dramatically. Meanwhile, we've got Yahoo, who was also $1 billion, dropped all the way down to $700 million. The reason is, these guys signed these long-term deals that were not justified in any common sense or logic. And these deals are rolling off the books.