Is Microsoft, the no-nonsense king of PC software, having a midlife crisis? Not at all. The software giant is trying on a new persona for a new environment. With PC sales expected to decline for the second straight year as corporate spending withers, Microsoft is aiming its big guns on entertainment goodies for the home.

It’s spending more than $2 billion building and marketing its new Xbox game console. And it’s sure to spend millions more on everything from its UltimateTV video-recording service to an online subscription music service to a handy wireless electronic tablet for the home, code-named Mira. On Jan. 7, at the Consumer Electronics Show in Las Vegas, Chairman William H. Gates III revealed Microsoft’s next-generation technologies aimed at making the PC the electronic hub of the digital home. They’ll route music, movies, TV programming, e-mail, and news between the Web and PCs, TV set-top boxes, gadgets, and stereo speakers. "Everything in the home will be connected," predicts Gates. And if he gets his way, most of the gizmos will use Microsoft software.

That’s why Building 50, brand-spanking new, is the digs for the software maker’s eHome division, a skunk works of more than 200 engineers responsible for turning Microsoft into the Sony of the 21st century. The digital home is the biggest market push by Microsoft since it launched its assault on server computing a decade ago, and the front-line troops are stoked.

In the next half-decade, Microsoft hopes to spark a revolution in consumer technology that transforms people’s home lives every bit as much as the PC has changed their work lives. The concept is far from new, but Gates and other tech execs say the timing is right now that the Internet has made many consumers more tech-savvy.

Microsoft is banking on its consumer business, to help revive growth. This year, sales from the consumer group will account for 12% of Microsoft’s total business. In fiscal 2003 that will jump to 18%—just shy of the 21% that’s expected from server products. That’s one reason why Microsoft’s stock is up more than 50% in the past year, to $70.

The consumer push comes at a time when the company seems to be coming out from under the cloud of its antitrust woes.

For all of Microsoft’s power and ambitions, though, the digital home may turn out to be the toughest market it has ever tried to crack. At best, Microsoft will be one of several top players, but it will never dominate digital entertainment the way it does PC software. Analysts expect the markets for video games, consumer online services, home networking, and interactive TV software to collectively top $63 billion in 2005. Microsoft could win in areas such as home networking, where its PC hegemony gives it an advantage. But it will lap in markets such as video game consoles and online services, where entrenched rivals rule.

Indeed, AOL Time Warner has a huge lead in the online service business with 33 million subscribers to Microsoft’s 7 million. And Sony may be even harder to beat.. Microsoft’s focus is primarily the software that goes inside the machines, and so its success depends, in part, on the smarts of its hardware partners.

Moreover, Microsoft has been missing the consumer gene for years. All of its major consumer-electronics gambits so far have ended up as disappointments. Its WebTV Internet-access service stalled at 1 million subscribers, and its interactive-TV technologies have gone nowhere. The company’s digital stereo speakers and PC-connected telephones were introduced in 1998 only to be abandoned a year later. And the gee-whiz technology in Gates’s suburban Seattle mansion—which includes electronic pins that each person wears to signal a preference in digital art, music, and temperature—has required as many as 50 servers, not the stuff of a simple consumer experience.

Even Microsoft’s allies are tinkering with rival software, not convinced that Microsoft will be the end-all in the digital home. Microsoft buddy Intel has used non-Microsoft software in some of its Web appliances.

Microsoft Hits Home With its software entrenched in home offices, Microsoft is aggressively reaching into the living room. Here’s how its strategy stacks up: Game Consoles Online Services Home Networking PCs Interactive TV Microsoft leapt into this $20 billion market in a big way with its Xbox launch in November. The company hopes to leapfrog rivals with online gaming that lets players compete from anywhere. The company is aggressively developing paid subscription services on MSN that will let users do everything from downloading music to synchronizing their banking and investment accounts. Microsoft is building links in every piece of its software in order to make PCs, set-top boxes, stereos, and handheld devices work better together. Reliable networking requires software, and that’s Microsoft’s strength. Microsoft has combined ever-more consumer offerings into the newly minted Windows XP. That has made it easier to do everything from organizing music files to gathering digital photos. Microsoft is aggressively hawking its set-top box software to cable operators, hoping to put its technology at a crucial gateway to the Web. Xbox is off to a glitchless start, but Microsoft hopes to capture 40% of the market in five years—a tall order, since Sony is No. 1. Analysts expect Microsoft to grab less than 25% of the market. Microsoft is the innovator in the consumer Web services world today. But with its 33 million online access subscribers to Microsoft’s 7 million, AOL has a firmer hand on the consumer’s wallet. Moreover, Microsoft is the only company that has both the software expertise and the lineup of devices to make home networking prolific. Microsoft’s strength on the PC is insurmountable. Windows ships on 95% of all PCs sold. That gives Microsoft a huge entree into consumers’ homes, where it can pitch its other products and services. Microsoft is still losing ground to its chief rival, Liberate Technologies in the market for software for TV set-top boxes. Several cable companies that Microsoft invested in chose rival software rather than waiting for Microsoft to get it right.

Microsoft is playing to win, though. It’s going about this with the patient, war-of-attrition approach that has been so successful in the past. The seeds of this assault were planted in March 1999, when Microsoft execs gathered at a retreat on the shores of Puget Sound to ponder their strategy for the home. Gates, and Ballmer, wondered if they could build a new generation of consumer devices based on PC technologies.

Microsoft’s brass decided to attack on all fronts. Microsoft seemed to turn the corner at the 2000 Consumer Electronics Show when it abandoned its tradition of setting up a series of booths to market its products. Instead, it created a model home on the showroom floor—complete with Jetson-like gadgets and a family of actors—to show people how digital technologies might shape their future. "That’s when the whole company got the `aha!"’ says Microsoft consumer products strategist Craig J. Mundie.

Microsoft decided it would build off what it sees as its "three pillars" for the digital home: MSN, Xbox, and Windows XP, which includes home networking technology. That way the software giant can leverage its strengths into new home entertainment categories such as online music. The plan now is to create specialized products in a wide range of markets rather than try to build an uber-box that would handle every function from gaming to spreadsheets. So, Microsoft teams are pursuing separate tacks on game consoles, consumer PCs, interactive TV, digital home appliances, handheld gizmos, and online services. "The way you get to our vision is by building individual products that are the best in their own categories," says Gates. "It’s like Microsoft Office. We built that with Word being the best, Excel being the best. They all had to be the best before the whole integration thing came together."

Although Gates says no detailed plan exists for integrating all these home products, Windows and the PC are central to the strategy. That’s why Windows XP, the newest version of the company’s operating system, is so important. After years of producing crash-prone software, Microsoft finally delivered an operating system that is more like a consumer appliance. Launched on Oct. 25, XP seldom crashes and is easy to use. And Windows XP’S home networking technology lets the PC automatically discover and connect such networked devices as digital audio receivers. "We’re moving Windows to the living room," crows James E. Allchin, group vice-president in charge of Microsoft’s operating systems.

Microsoft also is taking a page from its past playbook: It’s creating an ecosystem in which hardware makers and software developers can create products based on Microsoft technology. "We have partners who are doing cameras and screens and lots of peripherals that will let you reach out to all the different things around the home," Gates says. Already signed up: Samsung, Hewlett-Packard, and NEC, all of which are developing media center PCs that use eHome technology.

Those PCs will use a Microsoft software code-named Freestyle. In addition to peripherals such as a mouse and keyboard, PCs loaded with Freestyle would include a TV tuner card to connect to a cable service and a remote control to navigate the system from a couch. That way, consumers could organize their music files or home movies while they’re sitting at a desk and later, use the remote control to select tunes or videos from anywhere in the room. The first-generation, all-in-one Freestyle PCs will have all the functionality of a TV and a stereo. The target market: college students and apartment dwellers who might not have the space or budget for a PC, a TV, and a stereo. The second-generation Freestyle PCs will focus on the broad consumer market, selling boxes that sit next to TVs around the house and connect back to the main PC.

The first major connected-home product from Microsoft will be a gizmo code-named Mira. By next Christmas, consumers will be able to buy a flat-panel monitor that detaches from its stand and continues to connect wirelessly to the PC from anywhere in the house. With a stylus tapping icons or scrawling letters on a touch screen, Mom can check e-mail from the kitchen, the kids can chat with online buddies from the couch while watching MTV, and Dad can shop at Amazon.com from the back porch.

Microsoft is counting on Xbox to jump-start its digital home initiative. Already, Xbox sales are hitting the high end of analysts’ expectations. Since the launch on Nov. 15, about 1.5 million consoles have been sold.

For all the nifty technology, Xbox still needs killer games. So, while Xbox could become a sizable business for Microsoft, it’s only a piece of the puzzle.

The companies that win biggest in the home will likely be the ones with the most direct ongoing relationships with customers. Right now, that’s AOL Time Warner, which touches 46 million subscribers with its online and cable businesses. AOL is collecting $24 a month from most of the 33 million consumers who connect to its online service. And its Time Warner Cable unit gets another $54 per month, on average, from its 12.7 million homes. Microsoft can’t touch that. It’s lucky if it sells a home PC user a $90 operating system upgrade every three or four years.

And when it comes to mastering consumer technology, Microsoft sucks Sony’s exhaust. As cool as Microsoft’s Freestyle sounds, Sony already has introduced its Vaio MX media center PC, which does everything that Freestyle, aspires to. Microsoft’s Mira is nearly a year away. But more than a year ago, Sony introduced its Airboard in Japan, a flat-panel screen that can be used to check e-mail, surf the Web, and play video games. And Sony is developing networking technology, dubbed Feel that will make it easy to connect all of its devices to one home network.

Still, no company is better fixed than Microsoft to make long-term investments in the digital home. With $36 billion in cash, it can afford to invest heavily, experiment broadly, and wait patiently for the payoff. Microsoft’s history is loaded with examples of perseverance. MSN foundered for years before Microsoft figured out how to turn it into one of the top destinations on the Web. For most of a decade, its server software was the laughingstock of corporate computing. This year, it’s expected to claim 47% of the market.

So it’s not surprising that Microsoft is confident it will win in the home. "A lot of this stuff isn’t a question of, `Will the dogs eat the dog food?’ It’s `When?"’ says Microsoft’s Mundie. Maybe so, but competitors such as Sony have thrived by offering customers steak rather than dog chow. If Microsoft can’t match Sony, it will end up on the outside of the digital home, looking in.

By Jay Greene in Seattle, with Steve Hamm in New York, Catherine Yang in Washington, and Irene M. Kunii in Tokyo in BusinessWeek. Copyright 2002 by The McGraw-Hill Companies, Inc