May 7, 1999

In AT&T Deal, Microsoft Buys Stake in Future of Cable TV

By STEVE LOHR

EW YORK -- With a $5 billion investment in AT&T Corp., Microsoft Corp. on Thursday secured an inside track in supplying software for the high-speed communications networks of the future. But it has by no means assured that it will be the dominant supplier, as it is today in the personal computer industry.

In addition to a small stake in AT&T Corp., Microsoft's investment bought it a pledge that a version of its Windows operating system will power as many as 10 million next-generation set-top boxes in AT&T's growing network of television cable systems. That would be twice as many boxes as were originally supposed to run Windows.

What Microsoft did not get, though, may eventually prove more important. Taking a lesson from 1981, when IBM unwittingly set Microsoft on a course to dominate the computer industry by making it the exclusive supplier of the operating system for the IBM PC, AT&T confined Microsoft to a larger chunk of what will remain a highly competitive market.

AT&T's negotiations with Microsoft, according to people involved in the deal, were guided by two objectives: Get the money, but prevent the software giant from repeating its dominance of the PC business in the industry now being assembled around ultra-fast data networks known as broadband.

"What Microsoft got was the opportunity to get on the inside with us as we develop the technology for broadband," said John Petrillo, executive vice president for corporate strategy at AT&T. "What Microsoft did not get is an exclusive deal. It is not going to be the only company supplying us software for set-top boxes or anything else."

Thursday's announcement of the AT&T-Microsoft pact produced new details of a deal whose broad outlines had been previously reported. The companies have agreed to deliver digital services -- from interactive television to Internet shopping -- to homes in three cities next year. The local markets for the "model cities program" were not named, but Denver would be a likely choice for one pilot effort, according to one person close to AT&T.

Under a previous accord, AT&T had agreed to use Windows CE software in 5 million set-top boxes. AT&T said on Thursday that it would increase that commitment by another 2.5 million to 5 million set-top devices.

The 7.5 million to 10 million set-top boxes running Windows software represents 30 percent to 40 percent of the 25 million households to be served eventually by AT&T's cable networks -- after AT&T completes its acquisition of Mediaone Group and, as part of that deal, the swap of some cable operations with the Comcast Corp.

AT&T and Microsoft executives emphasized that the main purpose of the deal was to accelerate the deployment of high-speed services over cable networks. The goal is to upgrade the high-capacity pipes of the cable networks to deliver digital television, telephone service and high-speed Internet access to millions of homes.

C. Michael Armstrong, the chairman of AT&T, said that the pact was proof Microsoft "shares our strategy of using broadband cable to bring a new generation of digital communications, information and entertainment services to millions of American families."

AT&T will use Microsoft's $5 billion to help pay to upgrade the cable networks, enabling them to handle two-way communications needed for telephony, Internet messaging and interactive TV.

Microsoft is paying for a favored place in the next generation of high-speed Internet-based computing. Some analysts have called this future the post-PC era because they think the personal computer may not play the central role that it does today. Internet appliances of the future will likely include set-top boxes, handheld devices, digital wallets, cell phones and many others. That diversity represents a huge challenge to Microsoft, the technology standard-setter of the PC era.

The $5 billion, to be sure, represents only a slice of Microsoft's cash hoard of $22 billion. "This deal is not all that important financially, but it is of great strategic significance for Microsoft," said Richard Sherlund, a Goldman, Sachs & Co. analyst. "Broadband is a fat digital pipe to the home, and Microsoft desperately wants to be at end of that pipe."

In an interview, Armstrong said that Microsoft could be a major supplier to the broadband industry but it would not control the essential software technology as it does in the PC industry.

"The architecture of Windows is owned by Microsoft," he said. "Microsoft can dictate the technology specifications and programming interfaces."

But the broadband industry, Armstrong asserted, is a "very different situation."

In 1997, fearing that Microsoft could control the cable industry if it came to dominate set-top box software, the leading cable companies at the time said that Cable Labs, the industry's research consortium, would set the technology standards for digital set-top boxes. The industry's objective was to not become overly dependent on a single software supplier.

AT&T executives reiterated that commitment on Thursday. "We invite and solicit other vendors," Armstrong said.

And Petrillo, the AT&T strategist, said that one reason his company selected Microsoft as the set-top box supplier for the three test cities was that at this early stage Microsoft had the most complete product.

"This gets us to market faster," Petrillo said. "And we see Microsoft kind of as the rabbit in this game. Our judgment is that other software companies will respond to Microsoft and get going."

Sony Corp., with its Aperos operating system, is among the other leading suppliers of set-top boxes.

Sun Microsystems Inc.'s Java, an Internet programming language, is a software layer that runs on top of set-top operating systems, allowing software developers to write programs independent of the operating system underneath.

"We think that anything that drives the broader deployment of broadband is good for us, as long as Microsoft cannot move to undermine Java's role as an independent programming environment," said Alan Barantz, president of Java Software, a unit of Sun.

Still, by securing a larger role for Windows CE, Microsoft helps assure that its software will mesh not only with set-top boxes but also with many other Internet devices for which it is also developing software. That extra measure of compatibility, some analysts say, could give Microsoft a competitive edge in the post-PC era.

"The key is not what Microsoft earns, or not, from set-top box software but the spillover to all the other Internet devices in the home," said David Yoffie, a professor at the Harvard Business School. "This is a very smart move for Microsoft, and it is still uncertain how it will play out."

In the early 1980s, Yoffie noted, no one in the industry thought that Microsoft's basic DOS operating system was an issue. "People did not appreciate the software hooks Microsoft could put into DOS to make it so hard for users to switch, insuring a technology lock-in," he said.

Microsoft's investment in AT&T is complex financially. Microsoft will purchase interest-bearing securities that are convertible to AT&T shares during the next three years at a price of $75 a share. That is well above AT&T's current share price, which closed up $5 on Thursday, to $61.9375.

Also part of the deal, Microsoft will purchase a 29.9 percent stake in Telewest Communications PLC, a British cable TV company.

In a day when many high-technology shares dropped sharply, Microsoft closed down $1.1875 on Thursday at $77.9375.