How Microsoft Got Smart About Phones

Over the years, many Microsoft Corp. competitors and customers -- along with more than a few government regulators -- have concluded that it is a relentless monolith bent on using its hold over PCs to seize control of everything from digital music to the massive computer systems that run the biggest businesses.

But as Microsoft’s nearly decade-long quest to break into the rapidly emerging market for sophisticated wireless telephones shows, for all its determination and its $53-billion bankroll, the world’s largest software company doesn’t always win.

Despite spending more than $300 million in one of its largest research and development efforts and making unprecedented concessions on the look and feel of its software, Microsoft didn’t see its first phones for surfing the Internet and retrieving e-mail hit the U.S. market until last fall.

It’s too early to call the campaign a failure. Sales of so-called smart phones, now a small percentage of the 1.3 billion mobile phones in use, are growing quickly. Motorola Inc., which introduced the first phones with Microsoft software in the American market, says they will become the centerpiece of its strategy for selling to corporate accounts.

But the fragmentation of the phone industry, the fear among potential partners of being reduced to commodity providers like the PC makers and a backlash from Microsoft’s own aggressive tactics have combined to frustrate the giant from Redmond, Wash.

The experience should offer solace to those in Microsoft’s crosshairs, showing how ubiquity on PCs alone may not be enough to take the company as far as its executives and investors hope.

Like its gambits in video games and Web browsing, Microsoft’s cellphone campaign began as a defense against competitors.

In the mid-1990s, then-Chief Executive Bill Gates had his first pangs of worry as he watched consumers snap up hand-held computers -- especially those made by rival Palm Inc. His response was to assign 300 Microsoft staffers to create a stripped-down version of the Windows PC operating system, which became the basis for the Pocket PCs produced by companies like Hewlett-Packard Co. and Dell Inc.

Gates also was looking ahead to when hand-helds would converge with mobile phones, transmitting data through the air as easily as the spoken word.

The obvious hardware partner was Nokia Corp. of Finland, the world leader in cellphones. But by 1998, Nokia and its competitors had seen too much of what Microsoft had done to the computer industry.

Microsoft earned fantastic profit margin by licensing its Windows and Office software for tasks like word processing and schedule management, which cost close to nothing to reproduce. With little choice but to carry the latest Microsoft products, companies that make PCs agreed to onerous terms that left them with almost no control over what their customers saw on their computer screens. Consumers had few means for distinguishing between computers from different manufacturers; as a result, PC makers competed mainly on price and watched their profits vanish.

Determined to avoid a similar fate, Nokia and fellow phone makers, including Ericsson and Motorola, formed Symbian Ltd., a venture to develop operating systems for smart phones. The Symbian software would be licensed at the same rate to all comers, who could modify it as they saw fit.

The move enraged Gates, who spoke with Nokia’s chief executive on the heels of the Symbian announcement.

“I made it clear we were very disappointed and upset they didn’t ever talk to us about a group of companies coming together like this,” Gates wrote in a June 1998 e-mail to Microsoft executives that was later introduced in the Justice Department’s landmark antitrust suit accusing the company of illegally bundling programs into Windows. “Symbian is bad for us no matter what.”

Gates directed the company’s Pocket PC division to work “hard core” on licensing deals with the smaller phone manufacturers, which he referred to as “the seven dwarfs.”

Midcourse Correction

Before that could happen, Microsoft had to fix a fundamental problem with its technical approach. One of Nokia’s objections to Microsoft’s cellphone software was that it was basically the same as the Windows CE operating system that Microsoft created for hand-held computers.

That meant it had far too many features and was too complicated to use, industry executives said. It didn’t feel as if it was designed for a person using only one hand, as most cellphones are.

At a showdown meeting in December 1998, a large faction of Microsoft’s mobile devices team contended that the company should just add phone capability to its Pocket PC software, getting the product to market faster and satisfying a core audience of heavy data users.

Others said Microsoft should design a new cellphone operating system almost from scratch and aim to satisfy a broader segment of the population wanting voice calls first, plus a little Web surfing or e-mail.

That side won the vote, charting a painful midcourse correction that eventually kept Microsoft in the race.

“People know how to use phones,” said Microsoft smart-phone product manager Ed Suwanjindar. “It’s our responsibility to make data work on them.”

One year later, Gates demonstrated a smart-phone prototype, and Microsoft announced it had signed up its first handset manufacturer -- Sendo of Britain.

Sendo devoted considerable resources to the effort but said Microsoft couldn’t get the bugs out of the software. As the delay ate away at Sendo’s finances, Microsoft offered to invest in the firm. In return, it demanded access to Sendo’s hardware technology.

The relationship deteriorated after that. Microsoft withheld an interim payment for Sendo’s work, and Sendo accused Microsoft of trying to force it into bankruptcy so that it could gain free access to Sendo’s project designs.

“They put money into us, pumped us dry for everything we knew about how to make a telephone and tried to force us into bankruptcy,” said Sendo attorney Charles Babcock.

In a fraud lawsuit filed by its U.S. division in Irving, Texas, in 2002, the company accuses Microsoft of giving Sendo’s trade secrets to Taiwanese manufacturer High Tech Computer Corp., or HTC, which ended up making the first Microsoft-based smart phone. Microsoft has denied the allegations in the suit but declines to discuss the case in detail.

The HTC-Microsoft phone went on sale in Europe in late 2002 with communications service from Orange, the No. 3 European wireless carrier, owned by France Telecom. The handset sold poorly and brought widespread complaints about its reliability and short battery life.

Not Going It Alone

The Sendo debacle prompted another major change in Microsoft’s thinking.

Initially, Microsoft had been confident that the smart phones’ tie-ins to corporate e-mail software and their general familiarity to PC users would eliminate the need for Microsoft to partner with a big-name handset manufacturer. But executives said they realized they needed at least one seasoned phone maker on their side after all. And they saw that the best way to get that was through the handset makers’ biggest customers -- the furiously competitive wireless carriers that display the latest phones in their storefronts.

Negotiating with the carriers was far different from bargaining with a Sendo or HTC. They wanted the phones to draw their customers closer to them, not closer to Microsoft.

“The carriers covet this real estate on the screen,” said Harel Kodesh, who led Microsoft’s phone effort before leaving in 2000. Dominant Japanese carrier NTT DoCoMo Inc. and worldwide No. 1 Vodafone Group, he said, “want to dictate what the user interface is going to look like,” to the consternation of Microsoft staffers.

But Microsoft decided it couldn’t ignore the market, which grew 186% last year, with 9.6 million phones shipped. So the company switched to a much softer sell in its negotiations, agreeing to tailor its goods for every potential carrier and manufacturer.

“It’s been much less ‘You should be happy to work with me,’ and more ‘Let’s work together,’ ” said Alex Slawsby, an analyst at research firm IDC, echoing private comments by executives at partner companies.

Gates’ successor as CEO, Steve Ballmer, adopted the cause personally. He took AT&T; Wireless Services Inc. CEO John D. Zeglis to dinner in 2001 and promised that Microsoft would modify its software to suit the carrier’s needs.

Working together on “Project 520,” code-named for the highway connecting the two Redmond firms, engineers designed a version that steered customers to AT&T; Wireless’ lucrative mMode portal for news and entertainment.

An even better sales tool was a Microsoft-commissioned study predicting that users of its phones would send so much data over the air that they would generate twice as much revenue as regular cellphone subscribers. That has proved true in Britain with the HTC phone, Orange spokesman Stuart Jackson said.

Armed with commitments from AT&T; Wireless and Verizon Wireless, Microsoft went to Motorola and Samsung Electronics Co. of South Korea and asked them to make phones that carriers would pass along to new customers.

To close the deal with the manufacturers, Ballmer offered yet another set of sweeteners, including money for joint marketing efforts and, in Motorola’s case, a price break on PC software it was buying from Microsoft.

The $300 Motorola phone, released in October, has met with better reviews than its HTC predecessor, and its appearance has assuaged consumers and businesses that were holding out for a Microsoft phone produced by a manufacturer with a solid track record. Samsung released a $400 phone in November, though it hasn’t been as well received as Motorola’s.

Altogether, manufacturers shipped 459,000 Microsoft-based smart phones in the fourth quarter of 2003, four times the number of the previous quarter. That was far behind Symbian’s 2.36 million but enough to move ahead of phones that use Palm and Linux software, according to IDC.

Corporate Sales Hopes

Microsoft will benefit more when corporations decide to equip their staffers with smart phones, just as they did with hand-held devices, said analyst Richard Windsor of Nomura Securities. Such corporate buying could amount to 25% of the smart-phone market, and Microsoft should be able to take 80% of that segment, Windsor said. “It’s a no-brainer for the corporate customer.”

Still, Microsoft has been turned away by many big carriers because they don’t think the phones will sell well enough to justify the investment. Windsor and other analysts expect Symbian to stay on top in the overall smart-phone market.

“There’s low interest in taking on the costs of trying to do something that could generate a lot of customer service problems for very low volume,” said a ranking executive at one major European carrier.

Microsoft has two obvious ways to use its power to surmount such resistance, analysts say. One is to make its cellphones work better with its desktop software. The other is to press its growing advantage in audio and video software by ensuring that media clips play better on Microsoft phones.

Neither strategy would go unchallenged. An industry group partially backed by Nokia has already complained to antitrust enforcers at the European Commission -- who have ruled against Microsoft on other matters -- that the new PC operating system Windows XP unfairly tilts toward Microsoft phones. Likewise, competitors are watching Microsoft’s behavior in digital media for any overreaching they could take to the authorities.

For all the obstacles, Microsoft has no intention of giving up.

“They have endless resources, and they never go away,” said Michael Mace, chief competitive officer at PalmSource Inc., the software successor to Palm.

Smart phones are worth fighting for, said Microsoft product manager Suwanjindar, even if the company can’t capitalize on its preexisting strengths.

“It’s not a sprint, it’s a marathon,” he said. “We’re pretty good at marathons.”