[news=http://www.frogdesign.com/client/microsoft/graphics/logo.jpg]As the Internet transforms the way people use computers, Microsoft Corp. founder Bill Gates has a message for the world's biggest software maker: adapt or die.
"We must act quickly and decisively," Gates wrote in an Oct. 30 memo to Microsoft executives. "The next sea change is upon us."
In the four months since Gates put his company on notice, the maker of the Windows operating system and Office productivity suite has embarked on a restructuring no less significant than its adoption of the graphical, mouse-based user interface 20 years ago or its embrace of the Internet a decade later.
This time, Microsoft wants to diversify away from pre-packaged software and toward Web-based services that provide steadier, faster-growing income streams. In this vision, users would lease access to online software or use services in exchange for putting up with on-screen ads.
Gates warned his lieutenants that every part of the company would have to embrace the new market realities: "This coming 'services wave' will be very disruptive."
The pressure is on. Microsoft's sales grew 8 percent last year, a precipitous slide from the 49 percent annual growth rates of a decade ago. Wall Street has greeted its vast profit -- $3.65 billion last quarter alone -- with a yawn. The company's stock has stagnated for three years.
By contrast, rivals such as Google Inc. pull in billions of dollars for ads on free Web-search pages. Salesforce.com's leased sales-and-marketing software has given it revenue and profit growth above 65 percent . Apple Computer Inc. recently announced that it had sold the billionth download for the iPod, which has become the company's biggest revenue source.
"Microsoft hates the services business," said Jeffrey Tarter, executive director of the Association of Support Professionals. "If they can't solve the services problem, they'll gradually begin to see themselves drifting into a backwater."
But to embrace the next big thing, Microsoft risks further slowing the most prolific cash machine in software history and forcing product managers to take huge risks that could alienate customers.
"You have to mobilize everybody and get them to give up their private interests," said a longtime competitor who asked not to be identified. "It's like when a nation goes to war."
Not even Gates knows whether his company -- with 60,000 employees in more than 100 countries and $40 billion in annual revenue -- is still nimble and aggressive enough to reinvent itself.
A generation of investors has gotten rich betting that Microsoft would steamroll competitors despite constantly playing catch-up on key technologies. The company that touches nearly everyone on the planet who uses a computer knows how to move trends in its favor.
In the late 1980s, the old command-line interface on which Microsoft built its initial fortune was waning. Windows was regarded as a clunky joke compared with the graphical interface pioneered by Apple's Macintosh computer. Gates marshaled his forces. Microsoft powers more than 90 percent of the world's computers; Apple, less than 3 percent.
In 1995, Microsoft was caught off-guard when Netscape Communications' Navigator browser became the instant leader on the nascent Web. Gates and company countered with Internet Explorer. A few years and antitrust trials later, Netscape was out of business.
Gates has now set his sights on Web services..
A shift today might prove vastly harder, given the company's size. Since 1995, its payroll has tripled and revenue has risen nearly sevenfold.
Microsoft declined to disclose how much of that has come from services. Analysts said it was a minuscule fraction, because the company hands off most such work to consultants and resellers of its products. Large competitors, such as IBM Corp. and Oracle Corp., earn vast profits from maintenance and consulting, a backbone of the Web-services concept.
Since Gates' missive, the company has been rolling out "Windows Live" and "Office Live," which include free and fee-based Web site hosting, customer-management support for small and medium-size businesses, personalized home pages and revamped mapping, e-mail, address books and messaging.
The company is adding OneCare, a combination security and PC tune-up service, and plans to offer an eBay-like marketplace. It is gradually introducing AdCenter, meant to compete with Google by giving advertisers precise targeting of Web viewers.
Gary Flake, a Microsoft executive involved with the efforts, predicted that the protracted, multiyear process for creating new versions of Microsoft applications would gradually be replaced with nearly instantaneous improvements of Web-based services sparked by customer feedback.
Products can be revised "on a minute by minute basis, like the evolution of innovation itself," Flake said.
Flake, who was recently hired from Yahoo, said Microsoft had a radical goal: Erase nearly all distinctions between the Internet and computing.
"No one today thinks about how power gets through the lines to your home," he said. "But today we are very aware of the boundaries between our desktop computer and the Internet. We will see that boundary become invisible."
Microsoft faces a big problem with that vision: It could cannibalize its businesses that earn billions in profits in favor of unproven ideas. That contradiction has some analysts wondering how serious Gates is about making Web services the company's next epochal shift.
"Gates' choice to oversee the switch to services -- chief technology officer Ray Ozzie -- also has some Microsoft-watchers scratching their heads. He's considered a visionary, but he's also an outsider who signed on less than a year ago and lacks authority over the company's sprawling divisions.
Through a spokesperson, Ozzie declined interview requests, but in a widely circulated company memo he noted that "complexity kills. It sucks the life out of (software) developers, it makes products difficult to plan, build and test, it introduces security challenges, and it causes end-user and administrator frustration."
His work is complicated by a company culture devoted to big, complex products.
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Mark Lucovsky had been a top Windows engineer for 16 years when he defected to Google a little more than a year ago.
On his blog, he said Microsoft's endless product-upgrade cycles and bureaucratic responses to problems made it ill-suited to a fast-paced services model. Amazon.com takes the opposite approach, Lucovsky wrote, noting that a friend at Amazon found and fixed a defect that helped millions of users in a single day without any of them noticing the change.
"Not a single customer had to download a bag of bits, answer any silly questions, prove that they are not software thieves, reboot their computers," Lucovsky wrote. The companies to watch, he added, "have embraced the network, deeply understand the concept of 'software as a service,' and know how to deliver incredible value to their customers efficiently and quickly."
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Unlike earlier challenges that genuinely threatened Microsoft's survival, Web services are treated like one more number to cover on the roulette table.
"Microsoft has moved from a highly focused firm to a software conglomerate," said David Yoffie, a business professor at Harvard University. "They are betting on basically everything that has potential to be large and important on the software side of computing, communications and entertainment."
If so, the services push may be Gates using his famously effective paranoia to keep the company hungry, and partly a ploy to keep competitors off balance.
"Microsoft is going to remain a software company for as long as they possibly can," said Matt Rosoff, an analyst at Directions on Microsoft. "There's a bit of misdirection going on here."