By Matt Rosoff [bio]
Posted: Sep. 16, 2002

• Chart: Examples of Hosted Services

Hosted services will get a lower profile at Microsoft as it refocuses on its traditional business of selling software. This shift comes from a number of factors, including the inability of Microsoft to come up with compelling and lucrative hosted services, and the slow emergence of key enabling technologies, such as broadband Internet access and digital rights management. If this trend continues, ISPs and providers of Web-based services will face less direct competition from Microsoft and could receive new incentives to partner with the company, but companies and users who depend on Microsoft's hosted services might have to turn elsewhere.

Hosted Services a Response to Internet

Beginning in 1995 when Bill Gates sent a memo urging Microsoft employees to catch the Internet "tidal wave," the company started devoting significant resources to developing and operating hosted services—Microsoft-branded services offered over the Internet or another network. (For examples, see the chart "Examples of Hosted Services".) It's important to differentiate these hosted services from the more generic concept of "software as a service," which Microsoft uses to describe many things, including software that automatically updates itself (such as Windows Update) and subscription-like licensing models for traditional packaged software. Hosted services also differ from the company's professional service and support businesses, such as Microsoft Consulting Services.

Microsoft ventured into hosted services because many at the company (and throughout the technology industry) believed that the Internet posed a threat to desktop PC software. According to this hypothesis, as bandwidth increased, consumers and businesses would eventually store most of their data on networked servers and use Web browsers or other simple client applications to access and manipulate this data. As this happened, customers would no longer find compelling reasons to upgrade their desktop PCs or buy new desktop applications for them. The exploding popularity of the Internet and the growth of AOL—a company that charges a monthly fee for delivering application-like services over a network—contributed to the sense of urgency.

To counter this threat, Microsoft hoped to use its strength in the packaged software market—particularly its near-monopoly in desktop operating systems—to drive users to its own hosted services. For example, Windows XP asks users during the setup process if they'd like to sign up for MSN Internet Access, and contains the client software (Windows Messenger) for accessing the MSN Messenger service. Another example: Microsoft's Web browser, Internet Explorer (IE), which has been included with Windows since 1996, defaults to msn.com as its home page.

As the audience for these hosted services increased, Microsoft hoped to make money either by charging periodic fees or by selling advertisements.

Pendulum Has Swung Back to Software

Evidence from throughout the company suggests that the company has moved away from this strategy and will build and operate hosted services only if a clear business case is made for them. The following examples illustrate this trend.

Passport Express Purchase, a service that allows customers to store information necessary for e-commerce (such as their credit card number) and post it to Web sites without typing it in manually, is being cancelled. Its replacement, MSN Wallet, will only work with purchases made through MSN and MSN merchant partners. Microsoft earns money from these merchant partners, whereas it did not earn money from all Express Purchase transactions. (See "Passport Changes Include End of Express Purchase" in the October Update.)

Digital media subscription services. Windows Media Player 9, due in late 2002, will contain a "Services" tab with links to subscription services that offer downloadable digital media content, such as the Pressplay music service. However, all these services will be operated by partners, and Microsoft is no longer talking about expanding its digital media Web sites (e.g., MSN Music, WindowsMedia.com) into subscription-based services.

Visio Net Center (VNC) is a subscription-based Web site for Visio customers to download new network shapes. In Aug. 2002, due to low customer demand, Microsoft cancelled Visio Enterprise Network Tools, the only product that included a subscription to VNC, and it's not clear whether the site will continue to be updated. (See "Visio Net Center Shows Service Challenge" on page 19 of the Sept. 2002 Update.)

MSN 8, the next update to MSN, consists almost entirely of updates to the client software for MSN Internet Access. (This client software will also be sold separately to users of other ISPs.) This contrasts with nearly all of MSN's past updates, which focused on the MSN Web sites. In addition, MSN is no longer talking about the proposed fee-based services it has demonstrated in the past, such as an entertainment-oriented service involving music downloads, alerts, and concert-ticket purchases. (See "MSN Refocuses on Client Software" on page 24 of the Sept. 2002 Update.)

.NET My Services (HailStorm), announced in Mar. 2001 in a high-profile event for developers and media, was a plan to allow users to store personal data (such as their calendar and contacts) in a Web-connected repository hosted by Microsoft. Users would be able to access this data from a wide variety of devices and share it with third parties, such as friends and e-commerce Web sites. Microsoft hoped to make money by charging users fees to store and access their data. This plan has been scrapped for the time being, and Microsoft instead plans to sell software that enables other companies to create their own versions of .NET My Services. (See "New Strategy Devised for .NET My Services" on page 20 of the Apr. 2002 Update.)

Microsoft's TV-based services, such as UltimateTV and WebTV, have been deemphasized. One-quarter of the UltimateTV team was laid off, and both products have been moved into the MSN Division where they must compete for attention and dollars with the many other parts of MSN. Previously, they were among the flagship products of the much smaller TV Division.

bCentral cancelled two hosted services for small businesses in late 2001: Finance Manager, a financial data tracking service, and Site Builder, a template-based site design and management service. The site now encourages small businesses to use Microsoft packaged software—Small Business Manager and FrontPage—for these functions.

TransPoint and Expedia, the MSN bill payment and travel sites, were sold in 2000 and 2002, respectively.

Fewer services. The company's retreat from services is also reflected in the departure of Rick Belluzzo, Microsoft's former president and chief operating officer. Belluzzo was hired in 1999 to lead the company's consumer strategy and to figure out how to make money from consumer-oriented hosted services. As the company retreated from hosted services, Belluzzo was left with a less interesting role overseeing operations. (See "President, COO Belluzzo to Resign" on page 23 of the May 2002 Update.)

Strategic shift. CEO Steve Ballmer has indicated the strategic shift as well. In a Feb. 2002 interview with CNET News.com, he stated that he was no longer particularly interested in the services business: "When I see the money in .NET, I see software money. I don't see service money for Microsoft. . . . I'm happy to be in a very profitable, big business that we know how to manage, that we are oriented around, that we can think about."

Business, Technology Lacking

The shift back toward software reflects the difficulty of building profitable hosted services, the fact that necessary companion technologies are not ready, and the recognition that moving into new business areas can alienate partners and regulators and should not be done without a clear business case.

Difficult business. Few companies have figured out how to create a compelling hosted service that would draw enough users to make money. Of the thousands of advertising-supported and subscription-based Web sites and services launched in the late 1990s, very few have ever turned a profit. The application service provider (ASP) market has been decimated due to lack of customers, although some traditional consulting firms such as IBM and EDS have added solution hosting to their repertoire. (See "Lower Prices for Application Hosting" on page 20 of the Mar. 2002 Update.) Cable and satellite operators have drastically scaled back their plans for interactive TV-based services, which have never been popular. The ISP business has significant barriers to entry, and MSN Internet Access has never been profitable because of high customer acquisition costs.

In addition, Microsoft might have underestimated the infrastructure costs associated with hosted services. For example, to implement .NET My Services, Microsoft would have had to create or buy a billing and provisioning system that could track millions of events and users per day. This task has still not been completed, as evidenced by Microsoft's decision to roll out MapPoint.NET as a service for ISVs and Web sites with a simple two-tiered pricing plan, rather than a consumer service with a per-transaction or subscription pricing. (See "MapPoint .NET Shows Way to Commercial Web Services" on page 21 of the May 2002 Update.)

Slow rollout of companion technologies. For hosted services to be attractive, customers must have access to inexpensive and fast network connections. But prices for broadband Internet access have not dropped as quickly as Microsoft expected, and coverage remains limited, especially in the United States. (Steve Ballmer often remarks that he cannot get DSL or cable-based Internet access in his suburban Seattle-area home.)

In addition, hosted services that involve digital media, such as music download services, have been hampered by industry concern over unauthorized copying. Microsoft and other industry players are working to develop hardware-based copy-protection systems, but these systems will require widespread industry support and are still several years off. Furthermore, customers have shown little enthusiasm for the technology so far. (See "'Palladium' Plan for Trustworthy OS Revealed" on page 10 of the Aug. 2002 Update.)

Industry and regulatory alienation. Given the other negatives with hosted services, it's difficult to justify further alienating other companies and regulators to compete in these markets.

For example, because they view MSN as a threat, many hosted-services companies such as AOL, Yahoo, and Amazon have not bought Microsoft's server products and have formed business alliances with one another and with Microsoft competitors such as Sun Microsystems. It's unclear whether MSN, which has never been profitable, has been worth this lost business and public relations damage.

In addition, because of its near-monopoly on desktop operating systems and productivity applications, Microsoft draws scrutiny whenever it is perceived to be entering new markets. Most recently, privacy advocates pestered the U.S. Federal Trade Commission (FTC) to investigate Passport out of fear that Microsoft would create a "gateway" to the Internet and force all users to pay some kind of toll (either in the form of money or by sharing personal information) to access popular Web sites. The FTC took these complaints seriously enough to impose restrictions on Passport for the next 20 years. (See "FTC Resolves Passport Complaint" on page 33 of the Sept. 2002 Update.)

Breathing Room for Other Companies

Instead of relying on hosted services as a future source of revenue, Microsoft is betting that its traditional business, selling software, will continue to drive growth. In particular, the company will focus on getting customers to upgrade already-successful products (such as Windows and Office), getting its server products into data centers, and expanding its software market beyond the PC to devices such as cell phones and game consoles.

Meanwhile, the company will be extremely hesitant to build and operate new hosted services unless these services help the company sell software. For example, Xbox Live was approved because Microsoft believes it will extend the shelf life of the console and thereby help sell more Xbox games. (See "Network Vital to Xbox Success" on page 15 of the July 2002 Update.) The planned .NET Business Network, a business-to-business service to link suppliers and customers, was approved because Microsoft believes it will help sell enterprise resource management (ERP) applications to the previously untapped market of small and mid-size businesses. (See "Retail Point-of-Sale Software Company Acquired" on page 8 of the July 2002 Update.) But without a clear business plan in sight, the .NET My Services are unlikely to reappear as Microsoft-hosted services, although some of their underlying technologies will be incorporated into future server products.

At the same time, Microsoft's existing hosted services will face new pressure to become profitable. If they continue to lose money, Microsoft will cut expenses by reducing promotions (as it has done with MSN Internet Access), by reducing functionality or charging for previously free features (e.g., Hotmail Extra Storage), or by freezing further development and cutting personnel and budgets (e.g., UltimateTV).

Other companies in the hosted services business will not only gain some breathing room as Microsoft backs away but could also gain new partnering opportunities. For example, because Microsoft is not currently interested in building out its own digital media services, it must find partners to promote its Windows Media Player technology. Similarly, all the new Web-based services bundled with Money 2003 are provided by partners; in past years, Microsoft created its own Web-based financial services and incorporated them into the product. Existing Microsoft partners, such as OEMs and ISVs, could also find it easier to enter promotional agreements with other hosted services companies.

Finally, Microsoft will be less interested in establishing its own hosted services as de facto standards, and more interested in interoperability. For example, future versions of Passport are likely to interoperate with the Internet authentication services being proposed by the Liberty Alliance, a consortium of companies backed by Microsoft rival Sun Microsystems.