Gary Flake recalled scanning the faces of the three other senior Microsoft Corp. executives at a meeting last month and noticing that, like himself, they were new to the company.
They had all been key players in Internet services, a field that threatens the empire of desktop software that made Microsoft one of the world's most influential corporations. Before the meeting was over, he said, the executives agreed to complete this Internet coup -- from the inside.
"We had this realization," Flake, a senior engineer, said after the meeting adjourned. "We came to Microsoft to change the world. But the only way we're going to change the world is we're going to change Microsoft."
Never before in its 30-year history has Microsoft faced a more pressing need to turn its innovative prowess inward and remake itself. The company that became synonymous with computing for hundreds of millions of users worldwide is confronting an onslaught by rivals bent on stripping away Microsoft's customers by providing cheaper -- or free -- software over the Web.
Microsoft faces a dilemma common to many major corporations, including telephone companies, newspapers and automakers, as they wrestle with how to break loose from their traditional businesses before it's too late. Many have been unable to cannibalize their core operations, remaining intoxicated by the high profits they still provide. But the burden of maintaining the old businesses that made them titans can starve companies of the investment and initiative they need to innovate.
In the next several weeks, Microsoft plans to release new versions of the software responsible for its profitability and industry clout: a more sophisticated version of its Windows operating system called Vista and an updated business-productivity suite called Office 2007. Those two marquee products embody the essence of desktop computing and are on track for release to businesses on Nov. 30 and to consumers in January, Chairman Bill Gates said this week at the company's annual shareholders meeting.
Microsoft is at the same time reinvigorating its effort to scale the heights of the Internet with the release of Office Live, an Internet service for small businesses unrelated to the desktop programs Word and Excel that offers Web sites, domain names, company e-mail accounts and shared online workspaces. The service is part of Microsoft's bid to thread the Internet through its many of products and platforms, including game consoles, media players and corporate servers. Chief executive Steven A. Ballmer told shareholders that online services, along with entertainment, would drive growth in the future.
But for now, Windows and Office account for most of the company's revenue, an estimated $6.7 billion in the past quarter, about 62 percent of the total. And they present a fundamental challenge: each new release carries the baggage of the past because it must be compatible with all the software and hardware that ran on earlier versions.
Tens of thousands of engineering hours were spent on Vista, analysts said. It contains about 50 million lines of computer code, 40 percent more than the previous version of the operating system, Windows XP.
All that is hamstringing Microsoft's efforts at competing online.
"When I came to the company, I could see some people really got it with respect to the shift in the industry," Ray Ozzie, a celebrated engineer who joined Microsoft last year, said last week at an Internet conference in San Francisco. But, he added, "some people were heads down working on Vista, working on Office."
A new urgency
This is not the first time Microsoft and its 70,000 employees have revised its Internet strategy. But in the five years since Windows XP was released, the success of Microsoft's online ventures has taken on new urgency as high-speed Internet access proliferated, software migrated online and Web advertising spawned new media models.
The standard-bearer of the new Internet movement, Google Inc., has emerged as a pretender to Microsoft's throne. It dominates Web search and has introduced other services, including online spreadsheets and word processing programs that compete with Excel and Word. Google is also making the guts of its Web offerings, such as Google Maps, available to software developers so they can build their own products on top of them, much as an earlier generation engineered its software on top of Windows. Google's revenue last quarter increased nearly six times faster than Microsoft's, and its stock price is soaring while Microsoft's is generally unchanged since early 2004. The very mention of Google's name rankles many in Redmond.
For Microsoft, the Internet challenge is ironic because as much as any other company, it pioneered the age of personal computing.
"Anyone who writes them off does so at their own detriment," said Robert Horwitz, chief executive of the independent Directions on Microsoft research firm. "But it's not like the old days when they were quicker and more nimble. Microsoft has been surprised how difficult it is to create a new, profitable business."
To help it compete, Microsoft has been raiding Internet rivals and hiring people such as Flake, one of 14 Microsoft employees honored with the corporate distinction of "technical fellow." Flake and his colleagues at the meeting last month have already demonstrated they get the Internet. They included Steve Berkowitz, a former chief executive of the Internet search company Ask.com who became Microsoft's senior vice president for online services, and Debra Chrapaty, a former president of the E-Trade Group Inc. who is now Microsoft's vice president for Windows Live operations.
"Our products on the Internet are not today where they should be," said Flake, a 39-year-old with a strong, stubby jaw and even stronger opinions. "Part of the reason it's not there is because we've been focusing on a lot of different things."
Still, Flake said, he voted with his feet on the future of Microsoft. Early last year, he uprooted his family from California, where he had run research and development for Yahoo Inc., for a job in Redmond overseeing the laboratory that is developing Microsoft's online products. "The company is redefining and reinventing itself," he said.
Ozzie, the fourth and most prominent member of this insurgent fraternity, was named Microsoft's chief software architect in June, replacing Gates. Flake said the appointment shows that Microsoft is "unambiguously" committed to expanding its presence on the Web above all else. "It went from being a strategy to being the strategy," Flake added.
Ozzie is the rare pioneer who scored big not once but twice, first creating the e-mail software suite Lotus Notes and then founding Groove Networks Inc., which provides software that lets people work together on the Web. Four months after Microsoft bought Groove and hired Ozzie, he circulated an internal memo urging employees to rethink how the company is adapting to the Internet. "It's clear that if we fail to do so, our business as we know it is at risk. We must respond quickly and decisively," Ozzie wrote.
'We've come a long way. But our market share is down.'
Microsoft first turned to the Internet more than a decade ago with its MSN online service, which failed to produce big revenue and drew inconsistent corporate support. In the past two years, however, Microsoft's research and development spending for online services has more than doubled to $1.1 billion a year, Ballmer said. Capital spending in this area is up fourfold, to $500 million annually.
Even traditional software that runs on desktop computers is being redesigned to exploit the Internet, in a new hybrid approach. Windows Vista, for example, includes a feature that appears on users' desktops and offers online functions, such as weather reports and news feeds from the Windows Live service, Microsoft's latest Internet initiative.
The centerpiece of Windows Live is a search engine that Microsoft considers crucial because search is the primary method for navigating the Web. "We've come a long way. But our market share is down," said Christopher Payne, corporate vice president for Windows Live Search, who won approval from Gates and Ballmer three years ago to invest in search. He noted recent research showing Google pulling farther ahead.
Payne and other Microsoft executives stressed that the battle for the Internet is far from over. With a history of successful corporate makeovers, climbing revenue, $35 billion cash on hand and an army of expert software engineers, Microsoft remains formidable. Executives across the company concur that the company is uniquely positioned to marry features of desktop computing with the potential of the Internet.
But there is no consensus inside Microsoft over whether Internet services have ousted packaged software as the company's top priority -- or even whether they should. "The center of gravity is moving toward the combination," said Jeffrey S. Raikes, president of the business division responsible for Office software. "The best thing is to optimize the combination of that horsepower."
Ozzie said Microsoft's dominant position in desktop computing gives the company a rare advantage as it turns its attention to the potential of the Web. "I've got this audience," he said at the conference last week. "All we have to do is show them that we get it."