Is something wrong at Microsoft? It isn't fending off an emerging challenge to its monopoly. And it can't extend its dominance into new sectors. Is this the AT & T syndrome?

Pity poor Mike Rowe. The 17-year-old high school student and part-time Web site designer in Victoria, British Columbia, cleverly registered his personal site as www.mikerowesoft.com. He couldn't have anticipated that this would incur the wrath of Microsoft, which posted a 25-page letter to the startled youngster threatening legal action. Improbably, Microsoft warned him that its customers would be confused by Rowe's domain.

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The headline-grabbing story was another blister on the reputation of an organization seemingly intent on alienating the people to whom it sells. After the Rowe story broke, Microsoft went into overdrive to mitigate the public fallout, offering to cover the teenager's costs of redirecting traffic from his old Web site to a new one and giving him a free Microsoft Xbox video game console.

But Band-Aids notwithstanding, it's been a tough year for the software giant, with headaches ranging from allegations of patent infringements to billion-dollar lawsuits to European and Japanese antitrust actions. Following their brush with federal antitrust regulators, Bill Gates and Steve Ballmer don't appear to have regained the kind of momentum--and respect--the company once enjoyed.

Most recently, Microsoft was forced to play ER to eradicate viruses like the Blaster and SoBig.F worms that infected networks and mailboxes worldwide in 2003, and in February part of the source code for some versions of its Windows operating system was leaked over the Internet. The source code, an operating system's blueprint--the equivalent of the "secret recipe" to Coca-Cola--was available for downloading. Not only could hackers divine additional flaws in Windows, but if competitors get their hands on it, they could conceivably find out how Windows works and copy it.

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On the competitive front, the company's server business is losing market share to Linux-based servers, and its core Windows operating system is being challenged by Linux, particularly overseas. Microsoft also is losing money with Xbox, its stab at Sony's PlayStation 2 game console; and its Internet MSN venture is losing subscribers, down 1 million between October 2002 and October 2003. Although Microsoft announced record sales in the fourth quarter of 2003, its bottom line slipped. Profits in the quarter dropped 16.9 percent to $1.55 billion from the comparable period in 2002.

Not that anyone is predicting serious financial trouble for the Redmond software giant, thanks to its monopoly position on the desktop. But the company may well suffer from a longer-term backlash, given that rivals are gleefully ready to take advantage of every Microsoft misstep. "When Microsoft was a young startup launching Windows against Big Blue IBM and its OX2, it was the underdog, the company that got the emotional pull," says Mike Gotta, senior vice president at the Stamford, Conn.-based technology research firm Meta Group. "Today, a lot of people, customers and vendors just don't like Microsoft. The anti-Microsoft thing is growing."

The biggest imponderable is what is happening at the highest levels of the company. It has been four years since Gates relinquished his role as CEO to become "chief software architect." In that role, Gates vowed to develop software to "make things a lot better" for the world by 2010. The jury is still out on whether that's happening--and whether Balmer will be able to deliver on his lofty mission "to enable people and businesses throughout the world to realize their full potential."

With every new embarrassment, the possibility grows that Gates and Ballmer are distracted, or worse, simply at a loss of how to defend their company's position or extend its reach into new market segments. Despite repeated requests, the company declined to comment for this article.

Linux: Clearly Gaining

How intense is the Microsoft dislike? If you typed the words "Microsoft" and "bully" in the company's own MSN search engine on Valentine's Day, you would've reaped 24,060 hits. Had you keyed the same words into Google, you would've accessed more than double that number. Microsoft recently announced its intention to integrate search functions into the next version of Windows, code-named Longhorn, giving Google some competition.

Leaving aside comparisons with Netscape and the browser battles of the mid-'90s, the big question is whether the market will allow Microsoft to extend its monopoly into new product segments. "Microsoft leverages its monopoly to crush competition," charges Scott Piraino, a Fairbanks, Alaska-based independent Lindows.com analyst. Lindows is the software seller that used the open source Linux code to offer its proprietary software operating system, only to be sued by Microsoft in 2002 for allegedly taking advantage of its Windows trademark. "They just hate it when some pesky upstart dares to compete against them using Linux as a base," Piraino says.

Linux is the thing that strikes fear into Microsofties. The computer operating system developed by Linus Torvalds is continuously maintained and enhanced by a worldwide network of software programmers who are out to give Microsoft a run for its money. While Linux has ambitions to take on Microsoft on the desktop, it has been more successful in the Web server market, where its prime attraction is its ability to operate on low-cost Intel microprocessors as opposed to more expensive proprietary chips. Matt Eastwood, research director of IDC, says Linux servers grew in both revenue and shipments by nearly 50 percent in 2003 from the previous year, the sixth consecutive quarter of growth for the open source system. Linux's share of the Web server market increased from 23.5 percent in 2002 to 27.6 percent in 2003, while Microsoft's market share fell from 64.6 percent to 62.6 percent. And IDC projects Linux's share to rise to 45 percent in 2007, as Microsoft's share falls to 50 percent. "Far and away, Linux is the fastest growing operating environment in the server world," Eastwood says. "It was only in 2001 that Linux first surpassed NetWare in total server shipments and only in 2002 did it surpass Unix. This is an amazing success story when you consider that Linux started from such a small base."

As for the desktop, where Microsoft controls a 90 to 95 percent market share for operating systems and applications, it will be quite some time, perhaps more than a decade, before Linux cracks the double digits. According to IDC, in 2002 Linux operating systems accounted for 2.8 percent of client operating system license shipments; that number is projected to grow to 3.2 percent in 2003, surpassing second-place market leader Apple, and to 6 percent by 2007.

Still, Linux represents a strong challenge to Microsoft internationally and a growing menace domestically. Newer commercial Linux systems like Lindows and Xandros are an improvement over previous versions, offering quicker installation, improved integration with other devices and more bundled software. In short, Linux is catching up to Windows as far as functionality and ease of use. Best of all, users do not have to fret nearly as much about viruses and operating system breakdowns that wreak havoc for many Windows users.

Linux-based PCs, such as inexpensive Lindows-installed machines on sale at Wal-Mart, are projected to entice first-time buyers such as cash-strapped college grads. "Linux has a very significant following in specific applications such as browser, Internet applications and nonoffice-type environments," says Sam Greenblatt, senior vice president and chief architect of the Linux Technology Group at Islandia, N.Y.-based Computer Associates. "Microsoft is very strong in the knowledge worker and office applications, while Linux is strong in Internet-based applications."

Simon Yates, senior analyst of computing systems for Cambridge, Mass.-based Forrester Research, says his firm is receiving lots of questions from clients on the use of Linux and Java on desktops. "The Linux/Java combination can run quite effectively on older or less powerful hardware at lower cost," he says.

Yates also says many enterprises will be reluctant to upgrade hardware for Microsoft's Longhorn when it becomes available "since most will have upgraded in the 2004/2005 timeframe."

Even consumers are growing impatient with the amount they're spending on the Microsoft brand, says Michael Silver, vice president and research director at technology research firm Gartner. He explains that Windows as a percentage of the overall cost of a personal computer continues to rise. "Say you paid $1,000 for a new PC five years ago and today picked up one for $600," he says. "All the components of the computer have gone down in cost except the operating system." He reckons that five years ago Windows cost less than 10 percent of the total price tag of a PC; today, it represents more than 13 percent.

At the recent LinuxWorld trade show in New York, serious efforts were afoot to gnaw at Windows' dominance in different market sectors. Some Linux companies, for example, are aiming to bite a share of the market for computers that run one or two applications, such as retail checkout terminals and customer call centers. Elsewhere, Linux inventor Torvalds said that he would lead a drive for standards making Linux operate more smoothly on desktop PCs.

Goldman Sachs managing director Rick Sherlund says Microsoft's dominance at the desktop is slipping, albeit slightly. "Linux is taking opportunities away from Microsoft on the server side and the next target is the desktop," Sherlund says. "(Linux backers) are trying to get their act together now and over the next couple years will do just that. The small percentage of the marketplace that doesn't like Microsoft will want to take a chance to do something different, and that will translate into a couple of market share percentage point losses for Microsoft."

Global Resistance

Sherlund notes "definite momentum abroad" to embrace Linux, such as the decision last May by the city of Munich to migrate 14,000 desktop and notebook computers from Windows to Linux. "Add to that the desire by countries like China, South Korea and Japan to come up with an open system Linux for the desktop, as well as others that do not want to be dependent on an American-controlled platform, and one can see just how competitive a threat Linux is," he adds.

As more governments and organizations embrace Linux, others will follow. "The thing Microsoft hates most is a large successful migration away from them," says Gartner's Silver. "Successful high level migrations, particularly by governments, could spark more trial by enterprises. Microsoft takes this threat seriously."

So seriously that an email from a top sales executive at Microsoft to senior managers in the summer of 2002 hinted at dissuading governments and large institutions across the world from choosing alternatives to Windows. The confidential memo, leaked to the International Herald Tribune in May 2003, allegedly authorized executives to draw from a special internal $180-million fund to offer software to governments and institutions at a steep discount. Under European law, companies dominating a market are prohibited from offering discounts designed to block competitors. The memo warned: "Under NO circumstances lose against Linux," the newspaper reported.

Legacy of Litigation 

While Microsoft was able to negotiate a landmark antitrust settlement in 2002 with the U.S. government, it is now six years since the European Commission also charged the company with exploiting its monopoly power. More recently, Japan also is eyeing Microsoft's alleged monopolistic abuses. In February, officials from Japan's Fair Trade Commission made a surprise visit to Microsoft's Tokyo-based unit to investigate. Microsoft denied any wrongdoing.

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Meanwhile, Microsoft's troubles with the EC are building to a climax. EC regulators issued a draft decision in January that found Microsoft had violated European competition law on two counts, by failing to provide competitors in the server market with adequate data to enable their products to operate well with Windows and by bundling its media player into Windows. On the second count, the EC alleges that the bundling gives the company an advantage over rival products such as RealNetworks' RealPlayer. In December, RealNetworks took matters into its own hands and filed a $1-billion antitrust lawsuit accusing Microsoft of illegally monopolizing online video and digital music. RealNetworks CEO Rob Glaser alleged that government intervention had not been sufficient to stop "Microsoft's predatory conduct."

Goldman's Sherlund believes Microsoft "will capitulate to the EC and offer to bundle in the RealPlayer and other media players, which should also help resolve the RealNetworks lawsuit in the U.S.," he says. The company could face a fine of as much as $500 million. Last May, the company agreed to pay $750 million to AOL Time Warner to settle a suit filed on behalf of its subsidiary Netscape.

But given Microsoft's current cash position of roughly $60 billion, these fines are more nuisance than genuine concern. The constant barrage of legal accusations, however, continues to chip away at its reputation. "Lots of legal cases remain unresolved and they really need to get them resolved and move on," says Yates of Forrester Research. "The company needs to stay out of the legal spotlight."

Steve Kleynhans, a Meta Group vice president, says Microsoft is aware of negative public reactions and "is trying to be seen as a kinder, gentler Microsoft." Gates' Trustworthy Computing Initiative lists "trust" as one of its four pillars, along with security and reliability. "They realize their reputation is tarnished and they want to be perceived as a trusted business partner," Kleynhans adds. "But frankly, a customer grudgingly goes with a company's product when they don't have any other choice." The minute a customer has a choice, the temptation is to move away. "To me," he says, "that is the biggest risk for Microsoft."

Boxing Match

Microsoft has also had much trouble extending its dominance of the desktop to noncore businesses, as in the case of the Xbox. At an investor presentation in Boston in January, Microsoft CFO John Connors conceded that the current Xbox model will not be profitable. "With the current cost of goods, there's no way to make money with this generation of the console," Connors said.

The problem with the Xbox is less the box and more the games played on it, says Paul O'Donovan, a principal analyst at Gartner. "Sony's PlayStation 2 games are generally perceived by dedicated game players as being more exciting and worth-while than the games Microsoft offers for the Xbox," he explains. "PlayStation was out in the market ahead of Microsoft, meaning Sony could tie up a lot of game manufacturers and software developers. Microsoft is in the catch-up position."

Sherlund adds that Microsoft continues to lose money on the box and has not been able to make up for low volume. "They also shipped the box a year late, which has been very costly for them," he says. "And since they engineered so much into the box, their costs are much higher."

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The battle is about more than just a video game machine. Sherlund adds that the Xbox and Microsoft's Media Player "will morph into something more in the future--the envisioned home media center."

Analysts say the Xbox, MSN and Media Player are businesses for the future and early rough road should be expected. "Some of them will grow and some of them will die," Meta Group's Gotta says.

The chief stumbling block impeding Microsoft's entertainment enterprises is its tendency to dominate rather than cooperate, some analysts believe. "In the world of technology, core competency used to be writing code, but today it is about building coalitions," says Anthony Picardi, IDC senior vice president. "Microsoft is good at finding, evaluating and integrating software, but they are not good at coalition building." Picardi points to HDTV sets as an example of a situation where organizations had to cooperate to make it a reality. "But Microsoft has a culture that deters this kind of partnering," he says. "They're a monopolist, and their way of thinking is 'you either speak my language or take a hike.'"

While Microsoft has a couple dozen platforms coming out, Picardi says they are all based on a Windows kernel. "Does a Palm Pilot need Windows?" he adds. "Do smart phones need it? What about cameras, DVDs and TVs? All these things don't need to run on Windows. But when it comes to Microsoft, if it isn't a Windows platform they don't have any infrastructure for you. They have to shed that and, frankly, start all over again. They need a clean slate, and they need to figure out how to work with others."

In that way, Microsoft's monopoly power actually obstructs its other initiatives, Picardi suggests. "If they grow up and play ball with the other players, would they get more market share and continue their growth? The answer is yes," he says. "But with all their money, they don't have to do it just yet. They want to ride out their monopoly position for as long as they can."

For the near term, that strategy may work. But as AT & T discovered, it doesn't work forever. If the current trend lines are sustained for five to 10 years, the company could find that its core franchise has been eroded and that it hasn't been able to extend its dominance into new sectors. Indeed, if Gates' next big inspiration is really a Windows machine in disguise, the world may simply not buy it.

RELATED ARTICLE: MICROSOFT'S CHALLENGES MOUNT

Microsoft is still profitable ...

Record sales in 4th quarter, but profits dropped 16.9 percent to $1.55 billion.

... and has huge cash reserves ...

The cash stockpile is up to $60 billion.

Linux creator Torvalds is on a crusade.

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... but is beginning to lose share on the PC ...

2.8 percent of PCs sold in 2002 ran Linux operating systems, up from 1.7 percent in 2000.

By 2007, the number will hit 6 percent.

... and hasn't been able to extend its dominance in new sectors

* Linux will have 41 percent share of the Web server market by 2005 vs. Microsoft's current 28 percent.

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* Microsoft lost $874 million in the Xbox division in the year ending June 30, 2002, and $924 million in the subsequent year.

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* The company's MSN site lost 1 million subscribers from October 2002 to October 2003.

Microsoft continues to face embarrassments ...

Most recently, portions of the company's source code were leaked on the Internet.

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... and legal headaches

* The European Commission is expected to make a final ruling in April on whether Microsoft stifled competition in the media-playing software market.

* RealNetworks is pursuing a $1-billion antitrust lawsuit accusing Microsoft of monopolizing online video and music.

SOURCES: Company reports, IDC, press reports, Chief Executive