September 23, 2005 4:00 AM PDT

Microsoft's nightmare inches closer to reality

As early as May 1995, three months before Netscape Communications' initial public offering sparked the dot-com boom, Microsoft executives were worried that the nascent World Wide Web could one day become a significant threat to the Windows franchise.

In an extensive memo called "The Web is the Next Platform" that was introduced as evidence in Microsoft's antitrust trial five years ago, Microsoft engineer Ben Slivka described a "nightmare" scenario for the software giant.

"The Web...exists today as a collection of technologies that deliver some interesting solutions today, and will grow rapidly in the coming years into a full-fledged platform (underlined for emphasis in the original memo) that will rival--and even surpass--Microsoft's Windows," Slivka wrote.

Microsoft, however, didn't heed the warning. Instead, it embarked on a strategy--championed by Jim Allchin, who today heads up development of the next version of Windows--that was fanatically focused on the operating system.

Fast-forward 10 years: The nightmare is inching closer to reality and Microsoft execs are apparently paying attention to the decade-old alert. As part of a management shuffle, Microsoft said Tuesday it would make hosted services a more strategic part of the company and fold its MSN Web portal business into its platform product development group, where Windows is developed.

Another memo, called "Google--The Winner Takes All (And Not Just Search)," is also making the rounds. This internal memo, written in 2005, argues that Google threatens Microsoft and the company's crown jewel, Windows.

Just about the only thing that's changed over the last decade is that Microsoft's amorphous nightmare has a name: Google.

The MSN shuffle and that familiar-sounding memo come just as Google is poised to become the biggest threat to Microsoft's hold on the tech industry since Netscape shipped its first browsers. More than a few analysts believe that Google, with its massive array of networked computers and Web-based software, is rapidly expanding beyond its traditional search business and is about to collide with Gates & Co.

Google has about $7 billion in the bank to fund this fight. And it's already stealing the tech limelight from Microsoft--and significant mindshare from developers. Indeed, Google even managed to snag some top employees away from Microsoft, a trick Microsoft performed on its rivals countless times in the 1980s and '90s.

The MSN shift also brings full circle an argument that began inside Microsoft a decade ago: If the Web, not the PC, is indeed the next computing platform, should Microsoft embrace it wholeheartedly, or do everything in its power to ensure that Windows stays at the center of the computing universe?

"Google threatens Microsoft's position on the Internet, and could potentially lock Microsoft out of its existing distribution channels and reduce the value of Windows."
--2005 memo written by several Microsoft executives

A group of pro-Internet "doves" led by then-executive Brad Silverberg and Slivka argued in the mid-1990s that instead of digging in on the PC, Microsoft should beat its rivals by becoming the dominant platform for Internet computing, according to the book "Breaking Windows: How Bill Gates Fumbled the Future of Microsoft," by David Bank.

Ultimately, executives such as Allchin, who plans to retire once Windows Vista is shipped, won that internal debate. The Internet Explorer browser was folded into Windows; a separate unit dedicated to Web development tools was merged with other product groups; and nearly all of Microsoft's Web technology development was tied to the Windows platform.

It's hard to say, given what happened in the following years, that it was a bad decision. A badly bruised Netscape was acquired by America Online. AOL, back then a major threat, lost its importance. And from fiscal 1997 to the end of fiscal 2005 in June, Microsoft's annual revenues grew from $11.36 billion to $39.79 billion. Net income nearly tripled to $12.25 billion annually.

What those executives couldn't have seen back in 1997, however, was that a search engine recently developed by graduate students in a Stanford University dorm room would by 2005 become Google, a Net powerhouse on its way to doing better than $4 billion per year in business.

"Microsoft is facing a whole new slew of competitors in the 21st century that weren't around five to 10 years ago," said Michael Gartenberg, an analyst at Jupiter Research.

newsmaker
Gates on Google
Microsoft's chairman says the search giant is enjoying "the biggest honeymoon I've ever seen."

Today, Google is taking a page from the Microsoft playbook for tech dominance. It's wooing the third-party software developers who for years have written their programs for Windows--and increasingly are Google's Internet services as part of their Web applications. It's also luring some of Microsoft's top minds, including the controversial Kai-Fu Lee, an expert in speech recognition technology, and Adam Bosworth, a former Microsoft programmer extraordinaire who came to Google by way of BEA Systems.

Microsoft, it seems, is faced with a classic "innovator's dilemma," as author Clayton Christensen put it in his groundbreaking book that defined why tech giants usually miss the next wave of innovation. Microsoft execs made what looked like the right decisions at the time. As a result, the cash came in. The core product, Windows, became bigger and more complicated, and getting updated versions became harder to get out the door.

Plotting the counter-offensive
The burden of that success, as the theory in the book goes, makes it harder to respond to the next generation of tech innovators. Years ago, Microsoft and Apple rattled IBM. Now Google, some believe, has a chance to rattle Microsoft by providing a cheaper, easier-to-use alternative. "Every other time Microsoft was attacking from below," said one former executive. "Now (Microsoft) is being attacked from below and they don't know how to deal with it."

The Microsoft reorganization makes it clear just how seriously CEO Steve Ballmer and Chairman Bill Gates take that threat-?even if they won't exactly say it. "We've had lots of competitors in their honeymoon phase," Gates said about Google in a recent interview with CNET News.com. "But I'd say, in some ways, this is the biggest honeymoon I've ever seen."

Yet MSN's new prominence makes it clear that Redmond is focused

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