Responding to a wave of change on the Internet, Microsoft ( MSFT) is charting a new course that could ultimately determine whether the software behemoth once again sinks its rivals or is swept away by more agile competitors.

Recent memos from two top Microsoft executives revealed just how seriously the Redmond, Wash., company is taking the latest evolution of the Internet -- dubbed Web 2.0 -- into an ad-supported application platform.

But the jury is still out on whether Microsoft, widely viewed as a lumbering barge these days, will be able to navigate nimbly enough to be a leader in this next iteration of the Net.

"Microsoft is facing the greatest challenges that it's faced at any time in the history of the company," says Paul Saffo, a director at the Institute of the Future, a forecasting think tank in Palo Alto, Calif. "But I wouldn't be writing Microsoft off just yet."

Saffo ticks off a confluence of factors that have created the challenges, including its aging Chairman and Chief Software Architect Bill Gates and the company's difficulty hiring and retaining employees amid competition from Silicon Valley highflyer Google ( GOOG).

On a technology front, Saffo says that Web 2.0 represents a big change in the competitive landscape for Microsoft.

"In this case, it's really true the competition is in cyberspace," Saffo says, calling that a shift in the "intellectual design model" for Microsoft. "That's a big shift for a company that has gotten rich selling operating systems and shipping applications."

Saffo is referring to the movement of applications off of a user's desktop onto the Internet. Salesforce.com's ( CRM) hosted software is the most successful example of this, but start-ups and established players such as Yahoo! ( YHOO) are getting into the act, using technology that lets Internet applications operate more like desktop software.

Similarly, Goldman Sachs software analyst Rick Sherlund believes Microsoft faces new "architecture challenges" in the second generation of the Web, which he says is more about fully leveraging the Internet as a platform to deliver richer user experiences, software as a service, and community collaboration, among other things.

He points to the threat of companies such as Yahoo! and Google taking advantage of new technologies to offer free software online to rival Microsoft's Office suite.

"Looking at these developments, it could appear that Microsoft is again under assault by changing technology and, as with Netscape, off to a slower start than others," Sherlund wrote in a note Wednesday. He has an outperform rating on Microsoft and his firm has done banking with the company.

But both Sherlund and Saffo say that Microsoft can't merely make its software applications available via the Internet but instead must go farther by actually re-architecting the products for the Internet.

"Nobody is going to get rich migrating their word processors to cyberspace," says Saffo. "It is about creating new kinds of Web-based applications that just wouldn't be possible on the desktop to begin with."

Sensible Software

Saffo cites Salesforce.com's customer relationship management products as an example of software that makes sense to put online because that eliminates the need for a company to run its own servers.

But even beyond that, Saffo envisions completely new applications. One example might be a "mash up," or combination, of existing online services such as Craigslist apartment rental listings with Google Maps.

Not surprisingly, Salesforce.com's outspoken CEO, Marc Benioff, whose mantra has been "no software," is among those predicting Microsoft's doom amid Web 2.0.

In a panel discussion this week at a Goldman Sachs software retreat, Sherlund wrote in a recap that Benioff dramatically predicted "the death of Microsoft" and perhaps a similar demise for his other big rivals, Oracle ( ORCL) and SAP ( SAP).

But other analysts are hardly writing Microsoft's obituary. "If I was Marc Benioff, I'd really be watching my back," says Tim Bajarin, principal analyst with Creative Strategies, a high-tech consultancy based in Campbell, Calif.

"I understand Marc's thinking -- granted he's got a great lead," Bajarin says. "But boy, I never count out Bill Gates & Co."

Bajarin recalled the storied demise of Netscape after Gates belatedly embraced the Internet and bundled Internet Explorer with its operating system for free. Gates, he says, is one of the only executives he knows who can get everyone at a massive company like Microsoft moving in a different direction "literally the next day."

Or to mix metaphors, Bajarin says Gates can "turn an elephant on a dime."

Gates issued his latest call to arms in an Oct. 30 memo to executive staff and engineers, responding to what he called the coming "services wave." "The next sea change is upon us," Gates wrote. "But in order to execute on this opportunity, as we've done before, we must act quickly and decisively."

Ozzie

This time around, though, Gates is relying on help from a new lieutenant -- Chief Technology Officer Ray Ozzie, who came to Microsoft through its acquisition of Ozzie's company Groove Networks. The involvement of Ozzie, a widely respected innovator who created Lotus Notes, is not to be discounted, says Saffo.

"Ray is a brilliant, wild man," Saffo says. "He gets this stuff at the deepest level. No one has been working as hard on this."

Gates attached to his memo a seven-page, Oct. 28 memo from Ozzie, which included pieces that both executives a few days later repeated almost verbatim in speeches that heralded Windows Live and Office Live -- Microsoft's new online offerings .

Ozzie's memo, however, went into greater detail about Microsoft's past failures to respond quickly and decisively to some competitors.

"But for all our great progress, our efforts have not always led to the degree that perhaps they could have," Ozzie wrote. For example, "we knew search would be important, but through Google's focus they've gained a tremendously strong position."

Similarly, Ozzie pointed out Adobe's ( ADBE) lead with its PDF file format. "For all its tremendous innovation and its embracing of HTML and XML standardized Internet languages , Office is not yet the source of key Web data formats -- surely not to the level of PDF," he wrote.

In addition, Ozzie noted that despite Microsoft's capabilities in its instant messenger services, it was Skype, recently acquired by eBay ( EBAY), that popularized voice over Internet Protocol communications.

The CTO also credited rival Apple ( AAPL) with doing an "enviable job integrating hardware, software and services into a seamless experience with dotMac, iPod and iTunes."

To better execute on Microsoft's new vision, Ozzie said that the company would appoint division heads to take the lead on services-based initiatives, including reprioritizing and cutting projects. The business groups also are working on plans to create new service offerings.

Once again, the effort may prove to be another example of Microsoft being a good follower rather than a technology innovator. And that just may be enough for the world's largest software maker.

As Saffo says, " Microsoft is the best fast-follower on the planet."

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