In an effort to reach profitability, MSN is converting free services to fee-based services and will rely exclusively on partners to provide broadband ISP service. At the same time, Microsoft hopes to earn money from broadband users by creating value-added services for these users, perhaps including digital media services (such as music and video downloads). This shift in emphasis creates partnering opportunities for ISPs and other companies that can help MSN provide services to consumers, but it could alienate some users of MSN services and drive them to Yahoo or other competitors.

Two Businesses: Sites and Services

Today, MSN has two main businesses: free Web sites that earn money exclusively from advertising, and Internet-related services (such as MSN Internet Access, Hotmail, and MSN Messenger) that earn money from a combination of advertising and subscription fees, including periodic charges for special services such as extra e-mail storage.

Relative to other Internet companies, MSN has done fairly well with the first business, although it's unclear whether this business is yet profitable. According to MSN Vice President Yusuf Mehdi, the group stands to earn US$200 million in advertising revenues this fiscal year (which ends June 30, 2003), putting it very close to Yahoo. Moreover, these free sites have relatively low operational costs compared with running an ISP and other services, and a consolidated content posting and presentation system is expected to cut costs further.

But the services business is facing a decline in customers. In Microsoft's last fiscal quarter, which ended Mar. 30, 2003, paying subscribers to MSN services—including MSN Internet Access, the MSN 8 client software (which can be used by customers of any ISP), and fee-based online services such as Hotmail Extra Storage—declined from 9 million to 8.7 million. The previous quarter showed no growth.

In a speech to investors in May 2003, Mehdi blamed much of this attrition on dial-up subscribers switching to broadband. Until May 2003, when a nationwide co-branded service with Verizon launched, MSN Internet Access only offered broadband Internet access in areas served by partner ISP Qwest. Meanwhile, MSN 8 offered few broadband-oriented features, so users who switched to a broadband ISP did not opt to pay extra for MSN 8. Mehdi also suggested that some dial-up customers were leaving for lower-priced ISPs as free promotional offers expired.

Strategy to Boost Services Business

To improve the profitability of its services business, MSN is pursuing a three-part strategy: convert free services to fee-based services, slowly hand over the ISP business to broadband partners, and create new services that cater to broadband users.

Convert free services. Continuing a trend begun with Hotmail Extra Storage in Nov. 2001, Microsoft is converting several free online services to fee-based services. Beginning May 22, people using MSN Photo to store their digital pictures in an online repository were required to sign up for MSN 8, which costs US$22 per month (US$10 per month for users of another ISP) or lose their photo-storage privileges. On June 25, Microsoft will begin charging for MSN Calendar.

Relying on partners for broadband. MSN will rely exclusively on partners to provide broadband Internet access, leaving MSN to sell additional software and services to these subscribers. MSN has partnerships with Qwest and Verizon under which the ISPs handle provisioning and support and make MSN 8 the default client for users; the ISPs and MSN then split billing duties and revenues. MSN also has marketing agreements with Charter and BT under which these companies will promote the MSN client as an extra-cost (US$10 per month) add-on to their broadband service. In addition to the direct revenue that MSN gains from these customers, the MSN client contains many links to free MSN Web sites and services, where users see advertisements.

While relying on partners to provide broadband service to customers, MSN will continue to operate and improve its dial-up ISP business. Although this business has been hurt in the past by expensive customer acquisition promotions (such as offering a free year of access to users who bought certain PCs), now that these promotions are ending, Microsoft's dial-up business is "very profitable," according to its general manager, John Nicol. To retain these dial-up customers for as long as possible, MSN is investing in improvements to performance (such as better local caching) and reliability (such as automatically routing users around busy or malfunctioning access points).

Cater to broadband users. Although Microsoft does not plan to become a broadband ISP, it will offer fee-based services that cater to broadband users.

For example, in May 2003, MSN launched MSN Radio Plus, a fee-based version of its online radio service that offers extra stations, no advertising, and advanced search capabilities, such as the ability to search by artist, genre, or song tempo.

Mehdi said that future MSN services would focus on enhancements for broadband users, such as shared music playback (as currently offered in the threedegrees instant messaging client), enhanced instant messaging (including the ability to invite contacts to play an online game), enhanced e-mail collaboration (probably including the ability to start instant messaging sessions from within the e-mail client), and "maybe richer broadband things like video and music subscriptions."

Regarding this last possibility, Microsoft could launch its own digital media service, similar to Apple's recently launched iTunes Music Store, perhaps based on subscriptions instead of per-download fees. Such a service would not only attract users to MSN but could also help Microsoft sell software: the company believes that digital media will drive consumers to upgrade their PCs and buy new copies of Windows, and it recently introduced a software reference platform, Media2Go, for portable digital media players.

A more likely scenario, however, is that MSN will continue to link to digital media services run by partners. MSN already has a distribution agreement with Pressplay, which was recently bought by CD manufacturer Roxio. In addition, as part of a legal settlement with AOL, Microsoft agreed to work with its former nemesis on unspecified initiatives to make digital media more convenient and accessible to consumers while protecting copyrights.

Working with partners would help Microsoft reach its business goals without building a digital media service from scratch and having to contend with complex issues in which Microsoft has little expertise, such as building intricate per-unit billing systems and licensing large quantities of digital media content.

Resources

For background on MSN 8 and the most recent MSN business plan, see "MSN Refocuses on Client Software" on page 24 of the Sept. 2002 Update.

The MSN-Verizon joint venture is covered in "Verizon, MSN Team Up on Broadband" on page 27 of the Aug. 2002 Update.

For more information on threedegrees, see "NetGen Team Targets Youth" on page 25 of the Apr. 2003 Update; a beta version of the client is available at www.threedegrees.com

For background on how Microsoft believes digital media can help it sell software, see "Three Imperatives Drive Consumer Strategy" on page 25 of the May 2003 Update.