BW ONLINE DAILY BRIEFING

STREET WISE by Sam Jaffe	April 14, 1999

In the near future, you'll draft your business plan on a computer running the Linux operating system, play video games on a Linux game machine, make phone calls on your Linux cell phone, and, when you get cold, warm up by plopping some of those worthless Microsoft stock certificates on the fire. That's the dream of Linux enthusiasts -- and one nightmare for Bill Gates.

For such a vision (or nightmare) to come true, Microsoft (MSFT) would have to ignore the threat from Linux until it's too late. You can count that out. But the software giant does face a dilemma: How do you compete against a product that no one owns and is free?

So far, no clear answer has come from Redmond. But now and then slips of the tongue and document leaks provide a glimpse of the debate going on within Microsoft over how to do battle with Linux. The outside world's interest was piqued last week when the No. 2 man at Microsoft, President Steve Ballmer, said at an industry conference that Microsoft was considering opening the source code of Windows for the world to see.

Ballmer didn't elaborate, however, and other Microsoft executives were quick to downplay the remarks. "It really got blown out of proportion by the press," says Jim Ewel, the director of marketing for Windows 2000, the successor to NT that is expected to be released sometime this year. "What Steve said is that we are watching the open-source movement. Beyond that, it was a nonevent."

POSSIBILITIES. Still, at some point, Microsoft is going to have to do more than just watch the open-source movement sap market share away from its products. Microsoft could respond to Linux in one of three ways: ignore it, capitulate, or co-opt it. Each strategy is fraught with risks, each of which illustrates how dangerous Linux is to Microsoft's future.

The first option is to ignore Linux. If it is, as some believe, a fad, then Microsoft will only be adding to its buzz if it reacts aggressively. So far, Microsoft's strategy has been to plod along (turtle-wise) until the rabbit runs out of gas. But that hasn't been very effective. According to International Data Corp., Linux tripled its share of the low- to mid-range server market last year to 17%. Windows NT has 35% of that market, the same slice it had at the end of 1997. Clearly, its share would have been higher if not for Linux.

Microsoft executives, though, believe they have an ace up their sleeve. It's called Windows 2000 -- the next generation of NT. It is now in its third beta, or experimental, phase, and it's expected to be officially released by yearend. It could very well be that Microsoft's stasis in the server market is due to corporations waiting for Windows 2000 rather than buying a new version of the soon to be extinct NT.

Indeed, Windows 2000 promises to be a doozy of an operating system. It boasts more than 60 million lines of code and supposedly solves NT's scalability and stability problems. Early reports from testers of Windows 2000 point to a much more powerful operating system, albeit one that's still prone to crashing. If Microsoft's engineers can quell the flameouts, Windows 2000 could match up nose to nose with Linux.

OPTION TWO. But will that confrontation come too late for Microsoft? Already, Windows 2000 is far behind its expected completion date, and it could be delayed until well into next year. If that happens, Linux could own more than half the server market by then, which could give it enough critical mass to make it unstoppable.

The second option for Microsoft is to capitulate, open up the source code for Windows and Windows 2000 and make them both free. Such a bold move would ensure market dominance and would allow Microsoft to drastically cut its software development costs. The company would then be forced to make all of its profits off of its applications software, such as its database, word processing, and spreadsheet programs -- and off of its Internet content business, such as Microsoft Network and cable channel MSNBC.

Don't expect Bill Gates to go this route anytime soon. For one thing, Microsoft now enjoys gross profit margins on its operating system software of close to 85%. None of its Internet content businesses are making money. And some Microsoft critics are skeptical that an open-sourced Windows would be a success. "Windows 2000 is a train wreck of a program," declares Eric Raymond, a programmer and leading proponent of Linux. "Even if it were to be opened up to public view, it might be too big and unwieldy to be fixed by open sourcing it."

OPTION THREE. The third option is what Linux supporters fear the most: that Microsoft might somehow co-opt the open source movement by taking baby steps in the direction of freeing its code. In fact, a group of Linux supporters, including Raymond, wrote an open letter to Ballmer after his open-source remarks, urging Microsoft to open all of Windows 2000's source code or none of it. But while partially opening Windows 2000 might allow Microsoft to claim victory on the public relations front, it wouldn't do much for the bottom line -- and probably wouldn't make the operating system any more popular than it already is.

A variation of this strategy would be for Microsoft to allow anyone to view its source code, but not change it. That would allow developers to write programs that run well with Windows while letting Microsoft preserve its intellectual property rights and profit margins. Even this would be tough for it to swallow, though, because it would make piracy of Windows, which is already a problem for Microsoft, easier and more pervasive. It would also give applications developers the same advantage that Microsoft's code writers have in getting their programs to work with Windows.

In the end, it's hard to count out a company that has vanquished every threat, from IBM (IBM) to Apple (AAPL) to Netscape. But Linux is a different beast altogether, and, for Microsoft, a more elusive foe with which to do battle.

Jaffe writes about the markets for Business Week Online

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