• Chart: Non-Cable Broadband Investments
• Chart: Cable Investments

Microsoft has hatched a long-term consumer strategy based around broadband Internet access as a response to a declining PC market. The company believes broadband can deliver new, compelling applications and content that will prompt consumers to upgrade their PCs and software, buy other devices with Microsoft software, and subscribe to new fee-based services. As part of this strategy, Microsoft has invested more than US$10 billion in broadband distributors, primarily hoping to spur broadband adoption. These efforts could open new consumer markets for Microsoft’s partners and competitors alike.

Why Microsoft Needs Broadband

Microsoft has based its consumer strategy on the idea that fast, always-on Internet connections will eventually become widespread, replacing traditional dial-up connections in most homes.

It was forced to place this bet because the Internet-driven explosion of PC sales has finally come to an end. In 2001, worldwide PC sales dropped for the first time since 1985, and Microsoft Chief Financial Officer John Connors has cautioned that the first half of 2002 will also see flat or declining sales. Microsoft recognizes that consumers make up the largest market for new desktop PCs and the Microsoft software that comes with them (consumers bought 15.5 of the 17 million Windows XP copies sold in 2001), and it needs a new way to attract them.

With this in mind, Microsoft is relying on broadband to spur PC upgrades, drive sales of non-PC devices running Microsoft software, and drive consumers to existing and new fee-based services. This is primarily a consumer and small business strategy; Microsoft assumes enterprises already have a fast Internet connection, and is focusing on other issues in the enterprise desktop market.

Drive PC Upgrades

Microsoft hopes to drive PC upgrades by positioning the broadband-enabled PC as a hub for managing content and distributing it to a new generation of consumer electronic devices. For example, instead of playing a rented DVD on a traditional DVD player, a consumer could download a high-quality video file to a PC, edit it, and then transfer it over a network to an intelligent display device in the living room. The same PC could also store and transfer audio files to a home stereo, feed digital photos to electronic picture frames, and allow users to make voice phone calls over the Internet.

These "connected home" scenarios will require new PCs that are capable of fast networking and of decoding encrypted, compressed, high-quality audio and video streams. As people upgrade their PCs, they will buy the Microsoft software— particularly Windows—that comes with them.

To plan for the connected home, the company has added digital media playback and editing, voice-over-IP, videoconferencing, and wireless networking support to Windows; created an eHome Division to make digital media easier to use on a PC and distribute to other devices; and is encouraging manufacturers to think of the PC as a home electronics device and focus more on industrial design (e.g., use of space, fitting into living room decor), faster start-up times, and quieter fans.

Sell Other Devices

Apart from spurring new PC sales, Microsoft also believes broadband could convince consumers to buy other devices running Microsoft software.

PC-centric devices. Growth of broadband as a distribution medium for digital media will also grow the market for devices that transport and display that media. Examples include Mira, a technology that will enable nearly any type of display—such as detachable monitors or wall-mounted screens—to act as a PC terminal; Pocket PCs (users could transfer audio and video to these devices via a wireless network); Tablet PCs (could also display audio and video); and digital picture frames (which could act as displays for digital photos stored on a PC).

Other devices. Microsoft has created new product lines that are not PC-centric and is making sure that these products are ready for broadband. For example, the Xbox includes an Ethernet connection for easy plug-in to broadband connections. However, these non-PC-centric products are primarily defensive. The Xbox responds to the possibility that Sony's PlayStation or another game console might usurp the PC as the gateway for broadband services, including digital media (after all, game consoles are already in the living room and connected to the TV). Likewise, Microsoft has invested billions into interactive TV in case users decide that the TV—which has a far larger installed base than the PC—is the best device for accessing bandwidth-intensive services, such as games and video-on-demand.

Sell Services

Finally, Microsoft believes that broadband will help it sell existing fee-based services and pave the way for new ones.

MSN Internet Access has entered agreements with several companies to resell broadband access via high-speed digital subscriber lines (DSL), and Microsoft will roll out a broadband Xbox gaming network later in 2002.

In addition, Microsoft has spent considerable effort developing .NET My Services (once called HailStorm), a technology for storing users' personal information (e.g., calendars, credit card numbers) on the Internet and exposing this information to other people and businesses. Although some aspects of its original business strategy for .NET My Services have changed, Microsoft still plans to use .NET My Services as the basis for complex, fee-based services offered through MSN and future versions of its desktop applications. These services will require broadband connections to exchange the large amounts of data required and to ensure that this data is always available to applications. (See "New Strategy Devised for .NET My Services" on page 20 of the Apr. 2002 Update.)

Another likely possibility is services for downloading, storing, and sharing digital media. These would absolutely require broadband—consumers are not willing to pay for the low-quality files available over dial-up connections or wait for higher-quality files to download.

Broadband Investment Strategy

As it planned its consumer product strategy around broadband, Microsoft also made large investments in potential broadband distribution partners. Since 1997, the company has put more than US$10 billion into cable operators, DSL providers, telephone companies, fiber-optic networks, fixed wireless ISPs, and satellite networks.

Microsoft's main goal with these investments was to spur broadband adoption, particularly in the United States. But it also hoped to obtain proof-of-concept deployments for its broadband-related products (mainly the MSTV platform) and increase the pool of users for its fee-based services.

It has had varying degrees of success with all three goals, and these ventures have not been cheap: in 2001, Microsoft wrote down US$5.74 billion in unrecoverable losses on investments, primarily in European cable and telephone companies. The trend continued in Apr. 2002, when Microsoft wrote down US$1.2 billion from its 1999 investment in AT&T and the subsequent sale of AT&T Broadband to Comcast.

Spur Broadband Adoption

Apart from its cable investments, which have focused on interactive TV, most of Microsoft's investments were designed to subsidize the market for broadband. This was designed to keep prices low and spur rollouts, thereby increasing the overall number of broadband users. (For a complete chart, see "Non-Cable Broadband Investments".)

Microsoft did not invest in large incumbent telephone companies, such as Verizon and SBC; these companies were already making money from dial-up and integrated services digital network (ISDN) subscribers, and therefore had little incentive to build new high-speed networks. Instead, Microsoft put money into numerous small companies that posed high-speed challenges to the incumbents, such as NorthPoint and Rhythms NetConnections, which offered fast DSL connections over standard telephone wiring; fiber-optic network builder Qwest (which later bought incumbent telco US West); fixed-wireless ISPs Winstar and Teligent; and satellite network Gilat.

This strategy worked for a while—the number of U.S. broadband subscribers boomed in 1999 and 2000 (although Microsoft certainly wasn't the only investor in these companies). But by Oct. 2001, most of the small broadband providers were bankrupt or experiencing crippling losses. Faced with a less competitive market, broadband prices increased 12% in 2001, and broadband subscriber growth slowed from nearly 40% per quarter (in the first quarter of 2000) to 14% (in Q3’01), according to market research firm ARS.

Both Chief Software Architect Bill Gates and CEO Steve Ballmer have complained recently that broadband adoption is lower than they expected it to be, and statistics seem to bear out these complaints: although more than 80% of U.S. homes could get broadband service, only about 10% choose to do so.

Proof-of-Concept for MSTV

Microsoft's cable investments have been notably different from its other broadband investments. Rather than funding U.S. upstarts, Microsoft focused on the top one or two cable providers in several countries—Comcast and AT&T in the U.S., Rogers in Canada, NTL and Telewest in the U.K., and Titus in Japan, for example. (For a complete chart, see "Cable Investments".)

A U.S. regulatory quirk is partly to blame. Unlike U.S. telephone companies, U.S. cable companies are not required to open their networks to competitors, which leaves little room for new competitors. (This regulation was upheld in Mar. 2001 by the Federal Communications Commission.)

More important, this strategy reflects a different goal: most of these investments bought explicit promises to deploy interactive TV services based on the MSTV platform. Microsoft hoped these proof-of-concept deployments would show that MSTV is the best platform for the task, resulting in sales to other companies when interactive TV became popular.

But interactive TV has not become popular. Of all Microsoft's cable investments, only TV Cabo (a division of Portugal Telecom) has used MSTV in a widespread commercial deployment, and demand for this service has been low. (See "TV Division Changes Signal New Realism About Market" on page 18 of the Mar. 2002 Update.) Moreover, many "commitments" to MSTV were nonexclusive and seemingly nonbinding. For example, both UPC and AT&T complained publicly about Microsoft's slow delivery of MSTV and ended up running trials with competing software from Liberate. Neither company has yet deployed any commercial services using MSTV.

Guide Users to Services

Finally, Microsoft invested in broadband distribution companies so they would guide their customers to Microsoft's fee-based services.

It's still too early to tell whether this aspect of its investment strategy has succeeded. Qwest is currently transitioning its ISP users (broadband and dial-up) to MSN Internet Access, and Microsoft investees (such as Telecom in New Zealand and KT in South Korea) incorporate free Microsoft services or have made MSN their users' default home page.

But apart from MSN Internet Access and some experiments with Hotmail, Microsoft has not yet rolled out any fee-based services for consumers. (bCentral and the brand new MapPoint .NET are aimed at businesses.) Here, the company faces a Catch-22: the lack of broadband access means that it's not yet economically justifiable to develop bandwidth-intensive fee-based services, and the lack of compelling new services is a likely reason that consumers are not signing up for broadband access.

Content, Consolidation Shape Future

Despite its limited success so far, Microsoft is not planning any major change in either its broadband product or investment strategies. It will continue to improve existing products (particularly Windows) and develop new products with broadband in mind, and it will continue to make strategic investments that support its wider broadband strategy.

However, the details of this strategy are likely to shift in response to several market conditions, including a lack of interesting content, consolidation among broadband distributors, and continuing consumer indifference to interactive TV.

Lack of Content

One likely reason that U.S. consumers are staying away from broadband is because there is not enough digital content (particularly video) available to justify paying the higher price for a faster connection.

Here, Microsoft faces a big threat from AOL Time Warner, which not only owns an enormous storehouse of original content but also owns a potential broadband distribution network—Time-Warner cable, the number-two cable network in the United States. AOL also boasts 35 million ISP users, some of whom would undoubtedly pay more for the company's broadband services if exclusive content were available for download. (For background, see "AOL Time Warner Presents Renewed Threats" on page 10 of the Feb. 2001 Update.)

Microsoft is not anxious to repeat its content-creation experiments of the last decade—for example, it will not launch another joint TV network such as MSNBC. However, Microsoft is likely to invest in content companies and use these investments as a basis for content-sharing agreements. For example, Microsoft announced in Feb. 2002 that it had acquired a 15.4% stake in USA Networks, which owns cable TV stations, a TV production company, and several film studios. This is significantly larger than the 3% to 5% stake Microsoft said it would gain from selling Expedia to that company, and is particularly promising now that USA has been acquired by Vivendi Universal, a French media company with significant movie, recorded music, and print properties. Microsoft is also rumored to be considering an investment in ailing music company EMI.

Another likely reason for the lack of digital content is because content owners are reluctant to make their material available in digital format, which can be easily pirated. Record companies, in particular, have fought vigorously against one of the most popular uses of broadband Internet connections: distribution of MP3 music files. With this in mind, Microsoft will continue to develop its digital rights management technology and incorporate it into its operating systems (See "Digital Rights Management OS Patent" on page 14 of the Feb. 2002 Update.)

Consolidation

Owing to the high cost of rolling out broadband services and poor economic conditions, there are far fewer broadband distributors today than when Microsoft began investing in them. Most of the independent DSL and fixed-wireless providers are bankrupt; Microsoft's two U.S. cable investees, AT&T and Comcast, have merged; and many of its overseas cable investments (NTL, Telewest, UPC) are experiencing crushing debt and are expected to seek mergers or declare bankruptcy.

With this in mind, Microsoft began to alter its investment strategy in 2001. Instead of throwing money into risky and untested competitors that are building out broadband networks and services, Microsoft will invest in demonstrated market leaders that already have a significant number of broadband subscribers. Its Dec. 2001 investment of US$500 million in KT, the former state-run telecom of South Korea, is a perfect example. South Korea has the world's highest broadband penetration rate, with more than 40% of households subscribing, and KT is the clear market leader with nearly 3.4 million broadband subscribers. (Its nearest competitor, Hanaro Telecom, has about 2 million.)

Interactive TV Less Important

Microsoft seems to be facing up to low customer demand for interactive TV and scaling back its efforts. (For details, see "TV Division Changes Signal New Realism About Market" on page 18 of the Mar. 2002 Update.)

Although Microsoft will continue to work on the MSTV platform as part of its defensive strategy, it is extremely unlikely to invest in cable providers with the primary goal of spurring MSTV deployments. Rather, it will use its existing cable investments to subsidize broadband access and guide users to MSN and its fee-based services—just as it's done with other broadband-related investments in the past.