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Cover Story June 24, 2009, 2:34PM EST

Microsoft Defends Its Empire

Microsoft is under siege from rivals offering cheap or free software on the Web. So it's revamping its Office suite and shifting into online services

By Peter Burrows

When a Microsoft (MSFT) salesman dropped by IT consultant Westcon Group's Tarrytown (N.Y.) headquarters for a round of negotiations in late 2008, Westcon's chief information officer, William Hurley, decided he had had enough. "I'm sick of this," he said to the sales rep, complaining of the high costs of buying and maintaining Microsoft's broad portfolio of business software. "I don't want to do this anymore."

Much to Hurley's surprise, the rep offered alternatives. Within weeks, Hurley agreed to receive a new version of Exchange—the back-office software that makes corporate e-mail systems run—for a monthly fee, with Microsoft maintaining the bulky program and data on its own servers. The deal promised to save the company hundreds of thousands of dollars a year in hardware, software, and IT personnel costs. "This is a very different Microsoft than it was two or three years ago," says Hurley.

That's for sure. The Internet has thrown even the mighty Microsoft back on its heels. No longer able to impose its will on the computing world, the Redmond (Wash.) software giant is scrambling to catch up with all the changes the Web is unleashing. Over the past few years, CEO Steve Ballmer has come to two conclusions about the future of his business. First, Microsoft needs to move away from selling software and toward renting it out, in order to compete with cheap or free Web alternatives. Second, it must revamp its programs to satisfy customers' desire for more Internet-based collaboration. Now, Microsoft is putting those ideas into action, overhauling not only what it makes but how to deliver and charge for it.

The front line of the new Microsoft is its highly profitable business division. The group includes the Office suite of applications (Word, Excel, PowerPoint, and the Outlook program, which lets users read and compose e-mails), as well as its SharePoint collaboration software and its Exchange e-mail server program. Microsoft in November began offering Exchange and SharePoint as a Web service for a monthly fee. For customers tired of maintaining these unwieldy programs on their own servers, the change is welcome: They usually end up paying less to subscribe to the software than they spent buying the program and paying for the staff and hardware to run it.

What's more, Microsoft has dramatically upgraded its Office applications. Microsoft Office 2010, scheduled to be released by the middle of next year, represents a radical departure from the past. For the first time, Microsoft will offer a free version of Office with limited functionality to customers who don't want to pay up for the whole shebang. Among other things, the free version, which will be supported in part by online advertising, will let users access any Word or Excel document remotely, via cell phone or a Web site.

The paid version is much heftier. It will allow teams of workers to create documents, spreadsheets, and presentations as a group in real time and track down other people with a click and invite them to join in. It also boasts a broader array of fonts and formatting options and much more number-crunching power than the free version. By focusing less on the PC and more on the people who use them across organizations, "We're trying to redefine our notion of productivity," says 14-year Microsoft vet Ayca Yuksel, who demonstrated the software for BusinessWeek in June.

As of now, Microsoft hasn't committed to offering Office 2010 as a monthly subscription service like it does for Exchange and SharePoint. Instead it'll charge its normal up-front price, and companies will maintain the programs on their own servers. But company insiders say sooner or later Office is likely to go the subscription route as well.

Microsoft is betting that the subscription model will generate fatter revenues—and, indeed, it should. Microsoft can charge big corporate customers significantly more to rent software and contract for service than it charges them just to buy the programs. The wild card is on the expense side: Microsoft doesn't know for sure how costly it will be to assume the maintenance load. The answer will determine whether the company can afford to make Office or other programs available via subscription anytime soon. Hanging in the balance is one of the great profit machines of all time.

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