• Chart: Online vs. On-Premise Servers

Hosted versions of three Microsoft server applications—Communications Server 2007, Exchange 2007, and SharePoint 2007—are at the center of Microsoft Online, a set of new subscription-based services from Microsoft for large organizations. The move puts the company into direct competition with partners who offer hosted versions of those servers today. However, these online services will offer only a subset of server features, leaving gaps that partners can fill or supplement, and helping Microsoft avoid cannibalization of its on-premise server software.

Microsoft's Subscription Push

Microsoft Online is Microsoft's most ambitious effort so far to build a subscription-based business from its enterprise customers. At various conferences in recent years, such as meetings with financial analysts and partners, company executives have identified subscription services and "software plus services" as a high priority. Microsoft's highest-profile technical hire in recent years, Ray Ozzie, has a mandate to build subscriptions into a major business.

This effort is driven by increased competition from Internet-based subscription offerings, such as Salesforce.com's customer relationship management (CRM) software and Web-based productivity offerings from Google, Adobe, and others that compete with Microsoft Office. Although none generate the kind of revenue that Microsoft realizes from its on-premise servers, they have more buzz and are growing more quickly than Microsoft's businesses.

Enterprise customers are also becoming more interested in hosted software for several reasons, including the following:

• Difficulties in retaining qualified staff to operate and manage core enterprise services
• The complexity of managing desktop applications and licenses
• The ability of leading hosting firms to implement complex offerings, such as new regulatory compliance services, at lower costs than on-premise solutions; hosters accomplish this feat by using virtualization and server consolidation to achieve high hardware utilization rates, and distributing the cost across a large number of clients.

Industry analysts such as IDC and Gartner expect much of the growth in software revenues in coming years to come from hosted software and related delivery methods. To avoid inertia, Microsoft must explore software delivery alternatives.

More Public Role for Managed Services

Microsoft stepped into the managed services arena in 2005, when part of its IT department took on the task of managing desktops and Exchange and SharePoint servers for Energizer Holdings. The service was positioned as a small-scale experiment that would be limited to less than a dozen customers, but the number that it actually reached—two announced customers—suggests that Microsoft found running or selling the service harder than anticipated. Nevertheless, Ron Markezich, the head of Microsoft Managed Services (MMS), said in June 2007 that MMS planned to reach a significant segment of Microsoft's customer base.

The new Microsoft Online services bear MMS's name, suggesting that the experiment is over and that Microsoft is confident it can provide an attractive and reliable service to a larger commercial audience.

In line with the type of customers that MMS has lined up in the past, the new online services are initially aimed at enterprise customers with 5,000 seats or more.

Major Servers Head Lineup

Microsoft expects to roll out in "the next few months" a number of services, including subsets of Communications Server 2007, Exchange 2007, and SharePoint 2007, hosted by Microsoft and offered as an online service to organizations. Pricing has not been announced.

(For a summary of the server offerings and their feature sets, see the chart "Online vs. On-Premise Servers".)

Jeff Raikes, president of Microsoft's Business Division, said that whether customers license the servers to run on their own premises or purchase subscriptions, "they receive the same great technology." However, more detailed descriptions of the services indicate that the online versions will not offer the same feature set as the on-premise versions. In many cases, the missing features of the Microsoft Online services are the most notable new features delivered by the equivalent on-premise applications.

For example, Communications Server online does not include Voice over IP (VoIP) or new multipoint voice functionality and focuses mainly on instant messaging and presence features.

SharePoint Online does not include server-based Excel spreadsheets, integration with back-end enterprise resource planning applications, or enterprisewide search of a wide variety of documents.

Exchange Online does not include the unified inbox (e-mail, fax, and voice mail). However, it does include one notable service that is not in the on-premise version: support for BlackBerry devices. BlackBerry support is critical for many corporate customers, and Microsoft developed its Exchange Direct Push technology to compete with it. Microsoft's decision to support one of its leading competitors is a sign of how seriously the company takes its new subscription offerings.

The Microsoft Online services do not include desktop management, which was the centerpiece of MMS's services during its experimental phase. Microsoft may have discovered that desktop services are more expensive to run and less profitable than server-based offerings.

Service Design

Microsoft Online servers will use dedicated server hardware for each customer rather than multitenant installations. This was a relatively simple decision for Microsoft given that the minimum customer size is 5,000 seats. Microsoft will migrate customer's existing data, such as Exchange mailboxes, to its hosted servers (usually at additional cost),

Microsoft's service level agreements will guarantee at least 99.9% uptime at the data center, in line with what many other hosting services offer. (Failure of the customer's network or other services between the customer and the hoster are not counted against the guarantee.) If the hoster falls below that mark, customers typically get a free month of service or some other rebate.

One important asset of Microsoft Online is that Microsoft itself is supporting the data centers and software; when customers encounter problems, those problems can be escalated to Microsoft support teams.

Weighing the Strategy

Microsoft's hosted subscription offerings raise many significant questions, including the technical architecture that Microsoft will employ, the market segment the company is targeting, the impact it will have on the sales of on-premise versions, competition with Microsoft's own partner community, whether partners will have a role in selling the services, how customers will migrate from on-premise to hosted offerings, and how successful this offering is likely to be in the marketplace.

Target Market

Microsoft's focus on large companies substantially limits the market for Microsoft Online. In general, hosted and outsourced services have greater appeal to smaller companies, which typically lack the manpower to deploy and manage complex server applications. A May 2007 report from IDC, for example, found that companies with fewer than 100 employees used hosted or outsourced applications to meet 53% of their requirements, compared with 35% for corporations with 10,000 or more employees.

However, in limiting its offerings to enterprises, Microsoft is avoiding direct conflict with its hosting partners, who tend to focus on customers with 500 employees or less. In aiming at the enterprise, Microsoft is also heading off competitors such as Salesforce.com and Google, which have expressed interest in hosted or outsourced enterprise application services for enterprises and large organizations such as universities. At the same time Microsoft announced Microsoft Online, it announced Exchange Labs, which will focus on "next-generation" messaging capabilities in demanding large-scale environments, such as the universities and school districts where Microsoft expects to test it. Microsoft wants to limit Google's traction among educational institutions, a few of which have adopted Google Mail for their campus e-mail systems.

Subscriptions vs. On-Premise Licenses

The limited feature set in Microsoft's online offerings creates a dilemma for customers that the company will need to resolve—customers who opt for Microsoft Online will not have access to most of the new functionality that Microsoft delivered with the 2007 versions of its applications.

Microsoft has not explained how a customer who wants hosted IM and presence services as well as VoIP telephony or on-premise Web conferencing, for example, will get there on the Microsoft platform.

Based on what Microsoft has announced, such customers will need to buy both Communications Server subscription licenses and on-premise Communications Server Client Access Licenses (CALs), the former to provide IM and presence, the latter for VoIP and on-premise Web conferencing. The costs of such a solution could be prohibitive and could stall adoption of Microsoft's hosted offerings.

Similarly, Microsoft has not explained how it will transition customers from perpetual, on-premises licenses to subscriptions. Microsoft already has thousands of enterprise customers under long-term Enterprise Agreements, many of whom have acquired billions of dollars worth of perpetual licenses for desktop and on-premise server software and CALs. It seems unlikely that these customers would abandon that investment and move to subscription services unless Microsoft provides compensation or steep discounts. The company says that it will provide some compensation for customers who have Software Assurance (SA), Microsoft's upgrade rights program, on their software licenses, but it has not detailed how that will be calculated.

On the other hand, the differences between its online and on-premise applications could reduce cannibalization of Microsoft's current installed base. The company may be able to attract new customers who don't require all the features of its server applications and who like the low initial costs of subscriptions, increasing its base of customers and revenues. Customers who want the complete feature sets of these applications will stick with the on-premise versions. Finally, Microsoft Online gives Microsoft a potential annuity revenue from customers who do not have SA today.

Partner Competition

Microsoft already has a hosted software business, generating revenue from partners who have signed the company's Service Provider License Agreement (SPLA), and who resell hosted applications to customers. Many of those partners use tools from Microsoft's Hosted Messaging and Collaboration (HMC) group to manage their hosting services (usually employing multitenant architectures).

While hosted services delivered through partners do not appear to be a large revenue stream, Microsoft has indicated that it is growing rapidly, and it could grow even faster with the resolution of some outstanding pricing and licensing issues. The services available through the SPLA are identical to those that Microsoft is proposing to offer through Microsoft Online; only the 5,000-seat minimum limits Microsoft's competition with its current hosting partners, most of whom focus on smaller customers. Those partners may find the 5,000 seat limit disconcertingly easy for Microsoft to annul, should it want to extend its hosting business to midmarket customers.

Microsoft has not announced any plans to enable partners to resell Microsoft Online services and share revenue, in contrast to other planned online services such as Dynamics CRM Live (for which partners can get a 10% share of ongoing subscription revenue). On the other hand, partners may find niches around Microsoft Online, such as migrating customers from on-premise to online servers.

Services missing from Microsoft Online services are another partner opportunity: for example, customers who want to convert their telephone infrastructure to VoIP but also want Microsoft to host their instant messaging services may opt for the online version of Communications Server but get their VoIP and telephony integration from another vendor.

Success in the Marketplace

History is against Microsoft in the hosted applications space. While it has excelled as a products company, Microsoft customers—both consumers and businesses—have generally shown lackluster interest in its services offerings. As a consequence, the company's track record has a few services potholes, including failures like the "Hailstorm" initiative, the Microsoft Business Network, and money-losing efforts like MSN.

However, the company's resolve to develop subscription revenue from services has never been higher, and it coincides with a spike in market interest in hosted services and ubiquitous availability of essential enabling technologies, such as broadband access. These conditions could inspire Microsoft to repeat another common story in its history—years of following the market and mediocre results, followed by dramatic success.

Whither Software + Services?

Microsoft has hailed Microsoft Online as a major landmark in its "software plus services" strategy, but it does not appear to break any new ground on that score. Software plus services has many manifestations, but the canonical version blends on-premise or desktop software with some service that resides in the network "cloud," on Microsoft file servers. For example, Office Live Workspace, announced at the same time as Microsoft Online, lets Office users store documents on the Internet so that people can view, comment, and edit them more easily than if they were secured behind a corporate firewall.

Microsoft Online, in contrast, offers hosted server applications, a delivery model that has been available for more than 10 years and that generally replaces rather than complements on-premise software.

Pulling some features out of its online servers to differentiate them from on-premise versions might make them distinct from on-premise versions, but it does not deliver new utility or provide much insight for Microsoft customers on where the company's software plus services strategy will take them.

Resources

The new hosted server offerings are described at www.microsoft.com/online/bpi/default.mspx.

The rising profile of services and subscriptions was described in "Software Plus Services Becomes Urgent," on page 29 of the Aug. 2007 Update.

Expansion of managed services was covered in "Managed Services Strategy Broadens" on page 27 of the July 2007 Update.

Software plus services was outlined in "'Software Plus Services' Strategy Explained" on page 33 of the May 2007 Update.