Microsoft Challenges Yahoo!?

Today's Rule Maker article was written by guest columnist David Langford, who helped write content for The Motley Fool's recent biotechnology seminar and is a frequent contributor to the discussion boards -- under the name Wotdabny.

We try to invest in the best companies in the best industries, and sometimes we find overlap, which can mean competition. Often there's no reason to worry, as in the long run, competition is constructive.

Today we look at competition between two Rule Makers and a Rule Breaker, competition that's unlikely to benefit all of these companies in the short run, and which could radically change the investing landscape for one or more of these companies in coming years.

The issue is that Microsoft (Nasdaq: MSFT) is trying to establish a greater online presence, again. Before you yawn, know that this time, things really do appear different. Sure, Microsoft spent the last five years trying to beat America Online (NYSE: AOL)... and consistently lost the content and connectivity battle. So, Microsoft is trying a different approach, one that attempts to bring the battle to its home turf -- software.

Microsoft has already enjoyed enormous success with Internet software. Internet Explorer is the most often used, most stable browser around. Being highly modular, it has even been incorporated by AOL and Intuit's (Nasdaq: INTU) Quicken, among others, with simple but effective modifications. Even the brand-new, long-awaited Netscape 6.0 isn't as fast or stable as IE 5.5, the basis of Microsoft's new and provocative product. That product is the real topic of today's column: MSN Explorer.

On the surface, MSN Explorer is a browser with quite a few features and options. The user can choose to connect through MSN's online service or not; it has email and instant messaging; it's even easier to set up and get started on than AOL, if that's possible. Oh, and it's free. No doubt MSN Explorer will come bundled with all things Microsoft -- which means the company will be putting MSN Explorer right in front of tens of millions of users. Everyone will see it. The question is: Will they care?

Microsoft is acutely aware of this question and is trying, in its inimitable way, to make people care. MSN Explorer features permanent, non-removable buttons that carry you to predetermined Microsoft or Microsoft-partner sites. Even the homepage is fixed: it is and always shall be MSN, whether you like it or not.

As far as AOL goes, the whole thing matters only a little. AOL will still provide connectivity, and will likely continue to win on the content front. MSN Explorer shouldn't be ignored, but it's not the kind of thing that has AOL investors quaking. MSN Explorer is "just" a browser. The company that should be concerned isn't Rule Breaker holding AOL, but Rule Maker holding Yahoo! (Nasdaq: YHOO, which I own)

Whatever you think of Microsoft's strategy, it's sure to capture vast numbers of new users who will constantly see Microsoft's content, links, and all the usual goodies. Will these users ever even discover Yahoo!?

The Yahoo! Web experience is voluntary. People choose Yahoo! as they move freely through the Web, but people unwittingly choose and keep MSN Explorer because they are unaware of any other option. Thus, MSN Explorer has the potential to capture new users. Because MSN Explorer relentlessly redirects users to Microsoft properties, even Yahoo! users who give the free browser a whirl could be snared. Could MSN Explorer become the dominant portal over time? It takes the right software, creating the right medium, sold the right way, to effect the titanic revolution Microsoft is shooting for here. Let's look at those elements.

Microsoft has solid software, and it will be distributed widely indeed. The only criterion left is: Will the software create the right medium? If MSN Explorer offers another version of everything Yahoo! offers (and it just about does), could it come out on top after a few years and the necessary funding?

Considering only the above, I'd say there's genuine reason for concern. The full answer, however, depends on what you think the best long-term strategy is for capturing and retaining new users. I strongly doubt Yahoo! will turn out to be the nice guy who finishes last.

The way I see it, ignorant, unsophisticated, new users don't stay ignorant, unsophisticated, or new. They get some experience, and they want more. Sure, 80% of the time AOLers stay within AOL's garden walls, but MSN Explorer isn't offering AOL-type content, just links to Microsoft-friendly sites. As a browser, the inevitable reality is that users will surf, and read, and learn. They will figure out their own preferences and start choosing them. Ask yourself, how long after you first installed your current browser did you rely on the default bookmarks? How many of the original ones do you still use?

People like to customize their browsers. It's their online vehicle, and it should feel like home, not somebody else's property. Yahoo!'s software is extremely flexible and customizable, so people can make it their own. MSN Explorer isn't, and although this strategy of inflexibility will certainly scoop up some users and steal others, long-term dominance isn't possible over a population that naturally desires freedom, and the ability to own their experience.

How will Microsoft handle customers who would leave MSN Explorer for a less fettered online reality? Will their strategy change to one of flexibility once a customer base is established? If so, Microsoft will give up the future new users that continued inflexibility would have acquired. With flexibility, the walls come down. People would more easily find Yahoo! -- a dominant online property with an enormous lead over MSN, with revenues growing three times as fast as Microsoft's division.* Yahoo! might also decide not to ignore Microsoft's threat, and it has the resources ($1.8 billion in cash, savvy programmers, canny management) to do something about MSN Explorer if it needs to.

Microsoft has failed to bring the battle to its strong ground of software. MSN Explorer might literally be software, but the crux is the user's Web experience. Microsoft lost the preferred Web experience battle with AOL, and it doesn't appear to be setting up to win that battle against Yahoo! The best Microsoft can hope for, in my view, is an insistent third place.

*Yahoo!'s revenues grew 90% in the quarter ended September 30, 2000, compared to the same quarter one year ago. Microsoft's Consumer Software, Services, and Devices -- which includes MSN Internet access, MSN network services, WebTV Internet access and services; gaming, learning and productivity software; mobile and wireless devices, and embedded systems -- grew 31% over the same period.