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After the Vista debacle, Microsoft changed the way it makes software. The result – Windows 7 – is winning raves. Can a new operating system (and a new attitude) help the company take on Google?

With Microsoft’s founder and chairman, Bill Gates, trotting the globe in a quest to abolish diseases, his handpicked successor, CEO Steve Ballmer, has had most of a decade to move the company beyond its two biggest cash cows, the Windows operating system and the Office productivity suite. So far, not so good.

The company’s web forays, such as MSN, have only highlighted the dominance of Google and Yahoo. In software for smartphones, there is Apple, RIM (RIMM), and everybody else. MP3 players? Microsoft’s Zune hardly merits a mention. And even the core franchise has suffered. In the face of slowing PC sales and the economic pall, Microsoft’s fiscal 2009 revenue actually contracted, to $58.4 billion from more than $60 billion in fiscal 2008 — and the company missed its earnings estimate by more than $1 billion.

Fresh Coat of Paint: Artist Ricardo Richey, commissioned by Fortune, spray-paints a street-smartversion of Microsoft'sname and Window's logo on a San Francisco wall.

But the biggest failure under Ballmer’s tenure was self-inflicted. Vista was meant to be a wholesale reimagining of Windows, the brand name for Microsoft’s operating systems dating back to the early 1980s. Every so often the company unveils a new OS, blandly named for the year of the release (Windows 95, Windows 98) or a geeky abbreviation (Windows XP is short for Windows Experience). Vista had a marketing-friendly moniker, a fancy user interface, new security architecture, a better file-storage system, and much more.

After a protracted six-year development process, much internal squabbling, false starts, blown deadlines, and broken promises to partners, the engineering team mopped up 50 million lines of code, wrung it all out into a shrink-wrapped box, and heaved it onto the world in early 2007.

The timing couldn’t have been worse. Vista required top-end hardware to operate even while users were downgrading from desktops to notebooks. The bloated OS was incompatible with printers, web cams, and device drivers of all sorts. Early adopters scurried back to Windows XP; many corporations skipped the upgrade altogether. Worst of all, Vista energized the cloud computing chorus, led by Google (GOOG), whose vision of the future involves ubiquitous broadband, a good web browser, and everything else hosted on the Internet. No sophisticated operating system necessary. “Vista was the biggest debacle in the history of the company,” says one former senior executive. “People were ashamed to say they worked on it.”

But here’s some good news: On Oct. 22 Vista will be safely behind Microsoft (MSFT). On that day, the company will introduce a successor, Windows 7, and guess what? It doesn’t suck. In fact, it’s really pretty good. For all the pomp around each new version of the iPhone, the latest Kindle, or Google’s next beta, Wave, Windows 7 is sure to go down as the technology launch of the year. Critics love it, and IT managers are ready to buy. A recent Credit Suisse survey says that a quarter of corporate customers plan to upgrade within two years. Analysts estimate that the new OS could boost Microsoft’s revenue by more than $3 billion over that time and ignite the entire ecosystem built on Windows — from computer makers like Dell and Hewlett-Packard (HPQ) to third-party software vendors, resellers, and system supporters. It could be the shot in the arm the entire tech sector has been looking for.

On a warm September day in Redmond, Wash., sitting in a conference room in Building 34, the economic epicenter of the Northwest, Ballmer is not ready to declare the doldrums over. A stock market turnaround means little in the face of staggering unemployment. But he remains hopeful because he thinks this version of Windows is a winner. “It’s a great product. We did our best. Is that going to cause huge increases in spending by the world’s businesses? I can’t make that promise,” he says, “although I think things are becoming slightly less cautious. There’s some hope that says, ‘Hey, look, maybe this is part of the turnaround.'”

Back from the abyss

It’s just a hint of optimism from an executive who has been bearish on the economy of late, an indication that the mood is shifting at one of the most self-loathing, hypercritical corporate cultures you’re ever likely to encounter. As bad as the Vista years have been, Microsoft seems to be getting its act together. The Wall Street collapse stunned the company, and management reacted with uncharacteristic alacrity. “There was a week or two where everything seemed to come to a stop,” says CFO Chris Liddell, “and we said, ‘We’re going to have to operate in a different way.’ “The company laid off 5,000 employees and instituted a “10-point plan” to cut wasteful spending, from vendor allotments to travel and entertainment.

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Meanwhile, executives ramped up development cycles. This past summer the company kicked off, in its words, “a year of product launches unlike any other in Microsoft history.” Since then, Ballmer et al. have revamped Windows Server and unveiled the Zune HD line of MP3 players. On the way: overhauls of Windows Mobile, Office, Internet Explorer, Xbox Live, Bing (its new search engine), and the introduction of Azure, a plunge into the enemy territory of cloud computing. Microsoft is also about to venture into retailing, an area conquered by longtime nemesis Apple (AAPL).

All this, says Bob Muglia, president of the server and tools division, is part of what he calls Microsoft v.3 — a play on the old saw that it takes the company three releases to get a product right. “In the Vista era, we lost track of a bunch of things,” he says. “Now Windows 7 has shipped, and it’s the official start of [a time of] mature leadership, competitive focus, aggressive competition — and I think you see the results. You could say it’s us getting our mojo back.”

If Steve Ballmer has one attribute of a great leader, it’s an ability to inspire the troops — which is what he’s about to do standing onstage in July at a convention center in downtown New Orleans. The Big Easy is broiling in a midsummer haze. The locals have cleared out, making way for the 5,000 Microsoft partners — resellers, builders, software developers — who have gathered at a conference organized in their honor. Ballmer is, naturally, the headline act. He’s peeled off some pretty outlandish keynotes over the years, including “Steve Ballmer Going Crazy” (2 million views on You- Tube) — in which he huffs, “Come on, give it up for me!” — and the much-remixed “Developers” (1 million-plus views), where a heavier Ballmer performs a sweaty, arrhythmic stomp dance.

Today job one is to inject some optimism into the crowd. Ballmer had a tough year. He took a modest (for a man worth $11 billion) pay cut. But his small-business partners are reeling from the downturn. “This is the most phenomenal year we’ve ever had for technology releases,” he rumbles, ticking off reasons to be hopeful about 2010. Microsoft vows to keep investing $9 billion-plus in R&D, it’ll increase spending on partner support, and most of all it will keep fighting competitors — because, well, that’s what the company does best. “We don’t go home,” he says. “We just keep coming and coming and coming. We’re tenacious, tenacious, tenacious. Boom!”

That’s not entirely true. Over the years the company has cowered at least a few times. It bailed on Microsoft Money (a personal finance product designed to oust Quicken), would-be YouTube killer Soapbox, the long-forgotten BOB operating system for kids, tablet PCs, web-enabled TVs, etc. But the company has surely disrupted many markets — from web browsers to console games — by offering a fresh perspective. “Novell said, ‘The world is about single purpose operating systems,’ ” explains Ballmer, back at Building 34.”We had to say, ‘No, the world is really about multiple-purpose operating systems.’ Lotus and WordPerfect said, ‘The world is character-based,’ and we said, ‘No, let’s try some graphics.’ Apple said, ‘The world is a proprietary software-hardware combination,’ and we said, ‘No, the world needs to be open to choice.'”

The enemy within

Such conquests, while dated, have earned the company a reputation for being obsessed with competitors — a characterization Ballmer does little to diminish. Unlike most executives of his ilk, he says what’s on his mind, which can include calling Google a “house of cards” or referring to Linux as a “cancer that … attaches itself to everything it touches.” He once laughed derisively on camera at the prospect of the iPhone ever succeeding. But in Microsoft’s core business, there is no real competition. Various versions of Windows run more than 95% of all PCs. So when it came to preventing another Vista, Ballmer had to find the enemy within.

Windows 7 is a departure from Vista in many ways. It will be unveiled on time after a three-year development cycle. It’s compatible with previous versions and has excised all the security-permissions protocols that were lampooned in Apple’s “I’m a Mac” ad campaign. It’s sharp-looking, almost as sleek as the Mac OS, and has a few cool new features, like support for multitouch monitors and Aero Shake, which allows users to clear the desktop with a jiggle of the mouse. Perhaps most impressively, it requires less computing horsepower than Vista. That just never happens with a new OS. But the biggest departure comes in scope and ambition. Ballmer claims to have learned something from Vista: It’s no longer advisable to try a “big bang” rollout — i.e., completely reimagine a product as sophisticated and interconnected as Windows.

So he hit control-alt-delete. He brought in a new taskmaster, Steven Sinofsky, to oversee the engineering. Sinofsky became known for hitting deadlines while overseeing the Office group from 2000–07. An executive close to the Windows team characterizes his changes as such: “Reset — or reboot — is something that we hear a lot about the transition,” he says. “What we did was [give] the development team a clarity that was probably missing.” With Vista, teams worked on features simultaneously without an awareness of other schedules. When separate features came together, they were often incompatible. “The goal was to produce a plan for features, but not just a plan — also the motivation, the business rationale,” the executive says.

Sinofsky oversaw the largest beta test in history — more than 8 million users — blogged tirelessly about every little tweak, and kept lines open with partners. The team scrubbed inefficiencies and ushered out a fully functional, backward-compatible OS on time, earning Sinofsky a promotion to president of the Windows division. The new openness has resonated in the marketplace. According to Credit Suisse, 58% of corporate customers were either dissatisfied or extremely dissatisfied with Vista. With Windows 7, it’s 21% dissatisfied and none extremely dissatisfied. The PC makers seem happy too. “With Vista, the expectations were very high, and the customer reaction was not so positive,” says Satjiv Chahil, senior VP of global marketing for HP’s Personal Systems Group. “This time the response has been very positive. It’s what the market has been waiting for.” In the end Windows 7 is what Vista should have been the first time.

Software fades

With its house in order, Microsoft can safely get back to its imperialistic ways. And there’s no bigger land grab than web search. Ballmer has pledged to fund his new search engine, Bing, with as much as 10% of operating income over the next five years (potentially $11 billion). Why do something so risky when he’s lost so much online already? Because the opportunity is simply too big to ignore. Microsoft considers the global search market to be worth as much as $80 billion. And Ballmer recognizes that there’s even more power than money in being the leader. is what Windows used to be: leverage. Controlling the on-ramp to the web allows a company to distribute a broad array of products, which is what Google does so effectively. “They promote YouTube, they promote Chrome,” he says, referring to Google’s web browser. “If it was us, people would call it an unfair advantage.”

As the importance of client software diminishes, so too does Microsoft as we know it. Bing represents the company’s best hope yet of maintaining its own unfair advantage. And Ballmer thinks that Google, despite its enormous market share, is vulnerable. “There are a lot of negative views right now of what’s going on — Google Books, monopolization, blah, blah, blah,” he says, simultaneously highlighting and waving away a growing anti- Google sentiment. “Put all that aside and you have to ask, ‘Has the experience really changed much? Is it easier to find what you’re looking for? Is there a chance to do a better job?’ I think there’s a real opportunity to do that, and somebody had better seize it. Who’s got the best shot?”

Microsoft launched Bing in May, and it confirms Muglia’s assertion that the company has become more focused on customers. Rather than Google’s minimalist homepage, Bing rotates stunning photos embedded with interesting snippets about various parts of the globe. Like Google, the site acts as a jumping-off point, but has just enough flair to make you want to linger. Visitors see more information than they do in Google results and can even play videos without clicking away. Bing is organized more intuitively, and it outperforms in real-time search — a big plus for the Twitter set.

Early returns have been promising. Before Bing, Microsoft’s search engine, Live Search, had 8% of the market, according to ComScore. After three months Bing stands at 9.3%; meanwhile, Google’s share has dropped 0.4%. Over the summer Microsoft struck a deal for Bing to power the search function across many Yahoo (AAPL) properties. Once the arrangement kicks in, Bing’s share could jump to around 30%. “It’s a pretty good start,” says Yusuf Mehdi, SVP of Microsoft’s online audience group. “Best of all, it’s really hot with certain demographics, like elementary school children and women, because of the aesthetic design and feel.”

Of course the hope is that greater traffic will lure advertisers. Craig Macdonald is the chief marketing officer at media-buying firm Covario. He spends $250 million a year on search ads for clients like McAfee, Intel (AAPL), and Procter & Gamble. Impressed with Bing’s aesthetic and buzz, he initially increased spending, but has been disappointed. “We saw a 15% to 20% increase in impressions but a 39% spike in the cost of acquisition,” he says. Compared with Live Search traffic, driven primarily from the MSN homepage, Bing users are younger, more web-savvy, and frugal. “They did a nice job creating buzz, but we said, ‘We’re pulling back.’ ”

Microsoft may yet benefit from the anti-Google sentiment that Ballmer calls out. No one likes a monopoly, and everyone’s favorite web brand has become a freeloader in the eyes of the telecom, book, and media industries. Some of Google’s partners have grown disenchanted as well. “With Google, everything’s a black box, completely opaque. You have no idea why things go up or down. They’re impossible to deal with,” says the president of a website that each year generates more than $10 million hosting Google AdSense ads. “Everyone who’s not Google is rooting for someone to be a counterweight.”

It’s not obvious from walking around the company’s sprawling campus that Microsoft is locked in combat with some of the business world’s most ferocious competitors. There’s little resemblance here to the 24/7 sleep-under-the-desk startup culture that permeates Silicon Valley. Many executives are tanned and fit from weekend sails on Puget Sound, hiking up Mount Rainier, golfing, or exploring Machu Picchu. People arrive promptly to meetings, smile broadly, and are exceedingly polite. If quality of life were the most important metric for a recent grad deciding between Redmond and Redwood City, there really would be no choice.

The Valley set sees this as a sign of age and weakness. “They’re the IBM of this generation,” says Tod Nielsen, chief operating officer of virtualization software company VMware, who worked at Microsoft for 12 years and now competes with his former employer. “They’re profitable and successful, but there’s not a lot of excitement. It used to be the velvet sweatshop. Now it’s all about 9 to 5, 10 to 5 if you’re good, and 10 to 4 if you’re really good.”

Some ex-employees and analysts, none of whom spoke for attribution, agree that the company remains hugely inefficient and lacks vision. They also question whether Ballmer is up to the task of taking on Google, Apple, VMware, and so many other laser-focused competitors. “If shareholders could vote, I don’t think they’d pick Steve,” says a former vice president who claims to have left Microsoft on good terms. “It’s the whole ‘dances with elephants’ thing, and I don’t think Steve can be Gerstner,” he adds, referring to Lou Gerstner’s book “Who Says Elephants Can’t Dance?”, in which he details how he rescued IBM (IBM).

It’s an easy analogy — the old IBM and the current Microsoft both bulked up in a bygone era. But pre-Gerstner, IBM was on the brink. Its finance team held weekly meetings to see whether the company could cover payroll. With $15 billion in annual net income, Microsoft, on the other hand, is a cash machine. Even the great Vista failure must be viewed with perspective: It runs 350 million PCs. Analysts expect the Windows division to turn an $11 billion profit in fiscal 2010. And really, that’s Ballmer’s unfair advantage. The profits rolling off Windows and Office subsidize any lack of vision and allow the company to go the safer, more expensive route of chasing down Goliaths after new markets have solidified.

In search, Microsoft is confronting a Goliath with arguably as much market power. (Google has a $158 billion market cap, vs. Microsoft’s $230 billion.) Google’s new Chrome browser could prove a significant threat to Internet Explorer, which has already been encroached upon by Mozilla’s Firefox. Gmail is making headway with businesses in the battle against Exchange, not to mention consumers. Google Docs has spurred Microsoft to make parts of Office available online free in coming months. And then there’s Google’s Android OS for mobile phones. Launched in 2007, Android will operate more than two dozen heavily hyped phones by 2010, including T-Mobile’s MyTouch.

The battle between these two titans isn’t just about bragging rights or short-term profit. As our computing activity moves increasingly off our PCs into our phones, onto the web, and all around us, the most platform-agnostic company will rule. That presents Microsoft with a classic innovator’s dilemma: It must diminish, or at least ignore, its prior success to secure a place in the future.

Which is why Google executives like their position in this fight. “They are a very large incumbent in an area that’s shifting toward a new technology — cloud computing,” says Dave Girouard, president of enterprise for Google. “We are a company that was born of the cloud, and we don’t have to deal with the legacy issues they have to deal with.”

A year ago it would have been easy to agree with Girouard and skeptics who dismiss Microsoft as a sluggish incumbent. But the Windows 7 reboot has reinvigorated the company. In November it will launch Azure, a platform for building applications that are delivered via the Internet; as with Windows 7, potential users seem optimistic. For a change, Microsoft is even getting under Google’s skin: Google’s Chrome OS basically looks like a PR ploy designed to drive Ballmer nuts.

Whether the company circa 2009 truly represents Microsoft v.3, as Muglia suggests — the version in which Redmond gets things right — Vista is a turning point. It will be remembered either as a harbinger of a bloated company in decline, or it will be the wake-up call that prompted Ballmer and his team to set down a new path. Of course it will be years before we know how the Microsoft story, post-Vista, will play out. As Ballmer himself will tell you, “Plenty of people say everything in tech takes off or fails quickly. There’s nothing more laughable than that.”

–Reporter Associate, Kim Thai