• Chart: Web-Based E-Mail Services Compared

In a competitive response to Google's forthcoming Gmail service and changes at Yahoo Mail, MSN is making significant improvements to Hotmail, including adding virus-scanning to the free version and drastically increasing storage space for both nonpaying users and subscribers. Although the changes will probably decrease subscription revenues and increase costs in the short-term, they are necessary to keep the 170 million monthly visitors to the free Hotmail site from defecting, which could impact MSN's advertising revenue.

Gmail Setting the Pace

A new era of competition among Web-based e-mail providers began in Apr. 2004, when Google announced Gmail, a free e-mail service that will offer users 1GB of storage. At the time, the two market leaders, Hotmail and Yahoo Mail, offered far less storage—only 2MB and 4MB, respectively, for their free services, and a maximum of 100MB for paying subscribers, who paid up to US$59.95 per year. Gmail will also have several other features that distinguish it from Hotmail and Yahoo Mail, such as the display of e-mail exchanges as threaded conversations, keyboard shortcuts to perform common functions, and the ability to search all messages in the mailbox by keyword (a feature that Yahoo Mail also offers but Hotmail lacks). The advertising model for Gmail is also different: incoming e-mails are scanned for keywords (a method that has alarmed some privacy advocates) and then relevant advertisements are displayed on the right side of the page. In contrast, the free versions of Hotmail and Yahoo Mail display graphical advertisements that have no direct bearing to the content of the e-mail messages being displayed.

When Gmail entered wide beta-testing in June, Yahoo responded by increasing storage capacity and making other improvements to both its free and paid e-mail services. Now, MSN has announced that Hotmail will follow suit in July. (For an overview of all three services, see the chart "Web-Based E-Mail Services Compared".)

On the free Hotmail service, storage capacity will increase from 2MB to 250MB, maximum attachment size on outgoing messages will increase from 1MB to 10MB, and all messages will be scanned for viruses and cleaned if any viruses are found.

All Hotmail Extra Storage (subscription) offerings will be consolidated into a single program, Hotmail Plus, which will offer 2GB of storage, 20MB maximum attachment size, and other benefits, for US$19.95 per year. All existing Extra Storage customers will automatically be converted to Hotmail Plus when it launches, although MSN has not determined whether customers who have already paid more than US$19.95 will receive refunds. MSN Premium and MSN Plus customers will get the new storage levels as well.

The improvements will be rolled out at different times in different geographies, starting in July with the countries in which Hotmail contributes the most advertising and subscription revenue, including the United States.

A Necessary Cost

As a result of the changes, subscription revenue from the paid version of Hotmail will probably decrease and the cost of running the service will increase.

Subscriber numbers for Hotmail Plus are likely to drop because the free version now offers more storage and a larger attachment size than most customers will ever need, and the other benefits of Hotmail Plus (such as a lack of graphical advertising) are probably not significant enough to drive upgrades. MSN might address this problem by adding other features to Hotmail Plus, but even if subscriber levels stay even, the average revenue per subscriber will decrease because Hotmail Plus is only US$19.95 per year, whereas Hotmail Extra Storage had tiered pricing that ranged between US$19.95 and US$59.95 per year.

Adding storage will also increase Hotmail's costs, although MSN Product Manager Lisa Gurry suggests this additional cost will be "smaller than [one] might think" because adding storage is relatively cheap compared with overall operational costs, and because most users will probably use only a small portion of the storage available to them.

Nonetheless, Hotmail had to make these changes or it stood to lose a significant portion of its active user base and corresponding advertising revenue, which has become more important than subscription revenue to MSN's business. (For background on the importance of advertising to MSN, see "MSN's Evolving Advertising Business" on page 29 of the July 2004 Update.)