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Tech World Is Counting on Windows 98

Microsoft

(MSFT) - Get Microsoft Corporation (MSFT) Report

has a problem.

No, it's not earnings, since the software giant just reported another positive earnings surprise Wednesday for its fiscal third quarter. And no, it's not the

Department of Justice

probe, which is a real boon for lawyers, but not -- as yet -- the huge pitfall that most people were anticipating.

It's itself.

The company has to figure out a way to replicate -- and then surpass -- the extraordinary publicity campaign it developed three years ago to launch the now-ubiquitous

Windows 95

operating system (OS). Then, PC users were so excited about upgrading from

Windows 3.1

that "people were literally waiting for computer stores to open so they could get their hands on Windows 95," says John Girton, president of

Girton Capital Management

, and a former Microsoft analyst for

Van Kasper & Co.

Microsoft plans to launch an upgrade to this OS called

TheStreet Recommends

Windows 98

on June 25, and it already has released a beta version of the product to developers. So far, the comments on the OS are nothing for the company's formidable PR machine to highlight: "I've installed it and it's still needs a lot of work," says Gerry Libertelli, managing director of

G. Triad Development

, a New Jersey-based network-engineering and Web-hosting outfit. "I couldn't say the same thing about Windows 95, which I thought was a pretty good application right away."

Of course, Microsoft has never let an inferior product stop its momentum. But this time, the Redmond, Wash.-based outfit has more than just its loyal shareholders to please. Big chunks of the tech sector are awaiting Windows 98 as if it were the Holy Grail. Both

Intel's

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and

Compaq's

(CPQ)

CFOs alluded to the product during this quarter's conference calls, saying they were expecting an uptick in revenue growth in the second half due to Windows 98. PC distributors, computer stores and software makers also are hoping for it to kick-start what has been a sluggish PC market. Investors could even say that after Intel, Compaq and

IBM

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preannounced for their March quarter, Microsoft has been single-handedly propping up this tech market.

Since Microsoft reported earnings that were 2 cents better than the 48-cent

First Call

consensus Wednesday, its stock price has plummeted. It dropped 4 3/8, or 5%, to 94 1/2 Thursday and has fallen another 2 1/4 points Friday. This type of price action often occurs after a Microsoft conference call, when company management "talks down" expectations for the coming year.

Windows 98 is the most important product launch of the year, and the company needs to will people to believe that they need this new application. Currently, corporations seem hesitant. "For most business users I know, there is no compelling reason to switch to Windows 98," says Anthony Percelli, director of technical strategy for

The Princeton Review

. When business users were confronted with Windows 95 three years ago, they saw a marked improvement from its predecessor, Windows 3.1. Girton goes so far as to say that it was a big generational switch. Does he think Microsoft can have people sleeping outside computer stores again? "I don't see that happening with Windows 98," says Girton, who has no position in Microsoft stock.

As the world now knows, similar concerns were also raised before the PR blitz for Windows 95 began almost exactly three years ago. People balked at the size of the application, the price tag and whether it could help spur the entire tech sector to greater heights. Almost three years later, these worries seem almost laughable.

Michael Kwatinetz, an analyst with

Deutsche Morgan Grenfell

who has a buy rating on the stock, believes that since there are three times as many PC consumers out there than there were when Windows 95 was launched, he wouldn't be surprised if upgrade revenues exceeded those for Windows 95. (His firm did participate in one of Microsoft's recent offerings.)

Goldman Sachs

analyst Rick Sherlund estimates that 10% of the Windows 95 user base of 125 million will upgrade to Windows 98. The respected Microsoft bull, who rates the stock a buy, notes that even this relatively small percentage would produce $500 million to $1 billion in incremental revenues over a one-year period.

But taking another Microsoft success for granted could be dangerous. Investors seem to be giving tech companies the benefit of the doubt that the first half will be weak and that things will just "get better" in the second half. Many PC manufacturers expect Windows 98 to help because the new OS needs a faster computer (read: a more expensive PC that provides them with better margins) to run properly. The surge in sub-$1,000 PC sales, however, complicates things. Intel is not going to be able to sell as many of its higher-performance Pentium II chips that are assembled into box makers' pricier PCs. In the sub-$1,000 PC segment, Intel doesn't even use the Pentium II, but its new Celeron chip, which has been proven to be significantly inferior to rivals' chips. For Intel to make good on its promise of a second-half rebound, then, it needs a strong showing from Windows 98 to persuade people to buy more Pentium II-fueled computers in the second half.

For Percelli and other technical directors in the corporate world, it's the Windows NT upgrades (5.0) that are more eagerly anticipated than this summer's Windows 98 release. The two Windows NT 4.0 products, released in 1996 for workstations and servers, are still recording 40% to 50% annual sales growth after racking up 100% growth in 1997. These new 5.0 upgrades, however, aren't expected until early 1999. So they will not help give other tech companies a boost until the first quarter of 1999, at the earliest.

Tech companies need the conversion from Windows 95 to Windows 98 to happen fast. PC users seem pretty content with Windows 95 and they may not be so willing to fork over another $100 or so to upgrade. Some small corporations already have made up their mind. "In our budget meetings at the start of the year," says Percelli, "we agreed that we were still trying to recoup our expenditures from Windows 95 and Windows NT

4.0 and that we were not going to support Windows 98."

Now, more than ever, tech companies are relying on Windows 98 to be Microsoft's Next Great Product Launch to deliver the kind of improved results that analysts and investors are expecting. If these companies have to wait until 1999 instead, it could make for a very lean year for the Friends of Bill.