• Chart: AOL and Microsoft: Diverging Interests

AOL Time Warner has agreed to settle its private antitrust lawsuit against Microsoft for a cash payment of US$750 million. The two companies also agreed to share technology, license or distribute one another's products, and discuss cooperating in other areas, including digital media, digital rights management, and instant messaging. However, many parts of the agreement—particularly those relating to digital media—were only tentative and may not lead to significant changes, and the two companies will continue to compete in many areas.

What the Agreement Says

According to AOL CEO Richard Parsons, the détente between the two companies began with a personal phone call from Microsoft Chairman and Chief Software Architect Bill Gates in spring 2003. After several weeks of negotiations, the two companies announced a multifaceted agreement in May, some parts of which involve real change and others which are mere shifts in tone.

The following provisions are definite:

Lawsuit ends. In exchange for a US$750 million cash payment, AOL has ended its private antitrust lawsuit alleging that Microsoft used its monopoly on desktop OSs to dominate the Web browser market at the expense of Netscape. (AOL bought Netscape for US$4.3 billion in 1998.)

This resolves the most threatening antitrust litigation faced by Microsoft—in its initial briefs in Jan. 2002, AOL laid out a careful case based on an earlier appeals court decision in Microsoft's antitrust fight with the U.S. Department of Justice (DoJ), and the eventual outcome could have cost Microsoft more than US$1 billion. However, continuing the lawsuit would have been expensive for cash-strapped AOL, and the company decided to accept payment now rather than risk an uncertain payoff some time down the road. Although AOL is no longer involved, Microsoft continues to face other plaintiffs in the same case, including Be, Burst.com, Sun Microsystems, and a class of consumers who bought software through certain Microsoft Web sites.

The payment will make a small dent in Microsoft's more than US$46 billion in cash and short-term investments, but will affect the company's results for fiscal year 2003, which ends on June 30. AOL will apply the payment toward its approximately US$24 billion in debt.

IE license. AOL received a new, royalty-free license to use Microsoft's Web browser, Internet Explorer (IE), within the AOL client for seven years. (The two companies already had a similar agreement, but did not reveal the terms of that agreement or when it was due to expire.) This seems to spell doom for AOL's Netscape business, although CEO Parsons said he would not eliminate the unit "at this point."

AOL distribution. Microsoft will distribute the AOL client through its System Builder program. (System builders are small OEMs that build PCs from component parts and generally sell to businesses rather than consumers.) This opens a potentially important new distribution channel for AOL, as more than 50% of PCs today are sold by these manufacturers, according to market researchers Gartner and IDC.

More technical cooperation. AOL gains two dedicated Microsoft technical personnel to help resolve compatibility problems between the AOL client and Windows, and AOL will be allowed to maintain technical staff on Microsoft's Redmond, WA, campus. Microsoft has also agreed to share information about its upcoming client OS, "Longhorn," so that AOL can take advantage of advances in it.

Windows Media license. AOL signed a long-term, non-exclusive agreement that lets it use Windows Media 9 Series technology to create and stream digital media to consumers and protect that digital media from unauthorized duplication. (Terms of this license were not disclosed.)

In addition to these changes, the two companies will discuss the following issues:

• Opening AOL Instant Messenger (AIM) to interoperability with Microsoft's .NET Messenger service
• Building digital media delivery services that are convenient for consumers while protecting the intellectual property of content owners.

Diverging Interests

The agreement reflects the diverging interests of the two companies as each returns its focus to its core business.

After a burst of Internet-related activity in the late 1990s, Microsoft began retreating from Web-based services in 2000 and 2001, divesting itself of some services (such as Expedia), reducing functionality on others (such as bCentral), and eliminating prospective projects with unclear business plans (such as .NET My Services). As part of this shift, Microsoft's goals for MSN have become less ambitious: instead of engaging in expensive promotions to grow its ISP subscriber base and building out a wide array of new services, MSN will allow partners to provide broadband Internet access and focus on making its current user base profitable. (See "MSN Narrowing Focus".)

Meanwhile, since AOL completed its purchase of Time Warner in 2001, the combined company has faced a plummeting stock price and massive debt load and has restated some past earnings because of accounting irregularities. As a result, all the top executives that came from AOL have lost power or left, and the company is firmly in the control of former Time Warner executives who are more interested in media than in technology. Thus, with the two companies no longer directly competing in many areas, a stand-off was counterproductive for both. (For a chart detailing how the two companies have evolved, see "AOL and Microsoft: Diverging Interests".)

However, despite the agreement and the new conciliatory tone, there are still several areas where Microsoft and AOL will compete:

Broadband users. As users switch to broadband Internet access, both AOL and MSN are losing dial-up subscribers. To turn this trend into an opportunity, both companies plan to offer value-added services that will appeal to broadband users. However, these services will probably have limited overlap, as the companies have different strengths: AOL will probably focus on offering digital content from its immense storehouse of TV shows and networks, movies, and music, while MSN will more likely focus on IT-oriented functions such as better spam protection, parental controls, and Internet search. Another key difference is that AOL offers broadband service in some regions through Time Warner Cable, and could conceivably expand its broadband ISP service; MSN is not interested in being a broadband ISP and will rely exclusively on partners to offer that service.

Digital media. Although AOL now has the right to license Windows Media technologies, this is probably not a royalty-free license like the IE license, and AOL has made no decision on how much Windows Media technology—if any—it will use. AOL and other media companies have been wary of relying on a single provider of digital media technology, particularly one with such historical tenacity in other markets as Microsoft.

In addition, AOL has a long-standing relationship with Windows Media competitor RealNetworks. Among other ventures, Real, AOL, and several other record companies collaborated to build a music download service, MusicNet, which AOL began marketing to its customers in Feb. 2003. In the conference announcing the AOL-Microsoft pact, CEO Parsons was careful to note that AOL's license to use Windows Media is non-exclusive, and to reiterate that AOL will "continue to do business with Real."

Instant messaging (IM). AOL has fiercely resisted opening AIM because it believes that network effects drive users to the system and keep them locked in—the more of one's friends that are on a particular IM service, the more likely one is to sign up for that same service.

But two things could change AOL's position. First, AOL faces a restriction imposed by the U.S. Federal Communications Commission (FCC) as part of conditions imposed when it bought Time-Warner: if AOL wants to add any advanced functionality to its instant messaging systems, such as video capabilities, it must use an open standard that guarantees "server-to-server interoperability" or it must offer interoperability on a case-by-case basis with three other instant messaging systems within 180 days. If AOL cannot convince the FCC to suspend this rule, it might be forced to open AIM to keep it competitive with .NET Messenger, which already offers video.

More generally, closed systems could prevent IM from becoming a widely used business tool like e-mail. Although third-party software exists to bridge the gap between incompatible systems, if AOL sees the overall IM market stagnating, it could decide that interoperability will grow the overall IM pie enough to make up for any decrease in AOL's piece of it.

Resources

The details of the AOL-Microsoft agreement are not public, but more information, including a transcript of the conference call with Bill Gates and Richard Parsons regarding the agreement, is available at www.microsoft.com/presspass/legalnews.asp.

For background on the lawsuit, see "AOL Suit Reopens Browser Monopoly, Tying Claims" on page 22 of the Mar. 2002 Update.

For background on Microsoft's retreat from hosted services, see "Hosted Services Becoming Lower Priority" on page 22 of the Oct. 2002 Update.