(FORTUNE Magazine) – The Internet business is all about storytelling. With markets shifting at light speed, companies that can proffer a credible scenario for success gain a tremendous advantage. The best talkers often win. So think of Microsoft's big management change of mid-January as the opening chapter of an ambitious tale that's about to be spun. Yes, Steve Ballmer took over as CEO from co-founder Bill Gates, but the big news was the new story. The leaders of Microsoft are now telling us that the products on which they've built the richest company in the world--discrete packaged software applications, and operating systems that manage a single computer--will eventually disappear. What will replace them is not entirely clear. But the essence of the company's new focus is to get Windows-branded software into as many places on the Net as possible. There, it will serve as the basis for powerful, ubiquitous Web-based services. That's a fascinating--if somewhat mysterious--plot. Especially given the earnings news that came on the heels of the management shift: The numbers, as always, were terrific--quarterly net earnings rose 22% from a year ago, to $2.4 billion, on $6.1 billion in revenues. This company ain't broke. Why fix it?

These two billionaire buddies--they went to Harvard together and Ballmer served as Gates' best man--say they have no choice but to change the company in a big way. Not long before the AOL-Time Warner deal, Ballmer told FORTUNE, "If we don't transform well, somebody will cut our knees off." Just three days after the deal, Ballmer said AOL is definitely on a "collision course" with Microsoft. It's a massive headache, especially coming as it does on top of two other migraines. The most obvious is the ongoing battle with the Department of Justice and all the rumors that a breakup of the company might actually be what the government demands. Less clear, but perhaps more painful, is that Windows as we know it is starting to seem less and less likely to remain the dominant software in computing. As the Internet takes central stage, myriad computing devices are tapping into it. And for now, they don't need to use Windows.

It makes sense, then, that Gates and Ballmer have a grandiose story to tell, of big projects, of a massive change in strategy. They have changed their chief executive, and last year they reshuffled the managing decks below the CEO level. Now they say they are ready to change their products and virtually every aspect of how they do business. As they launch their company in this new direction, think of the story Gates and Ballmer are spinning as a Stephen King novel. In its details, as we'll see, it leaves a lot to be desired, but their tome is impossible to ignore, and if the authors get it right, it may prove frighteningly irresistible.

On the day of the management announcement, Gates sent what Microsofties refer to as "mail" (everywhere else it is called e-mail) to all employees. He explained that Microsoft's success is built upon its commitment to the graphical user interfaces, or GUIs, in its Windows operating system and the Office applications that work with it. Then he added: "Today we must make a similar bet on using software to improve the way people experience the Internet--an even more important revolution than the GUI." His new title is chief software architect, and he'll guide the technical and strategic transition.

To get a sense of just how big a job this is, consider a key bit of Microsoft history. In its earliest iteration, circa 1985, Windows was little more than a new face for the DOS operating system, replacing lines of typed commands with pull-down menus, icons, and toolbars. Over the years, that graphic interface was integrated with the programming behind it, turning Windows into the powerful operating system used today on virtually all PCs. Now Microsoft may well be putting a new face on Windows--a face that looks out to the Web as well as in to all the data and software on PCs and the servers that run corporate networks. That's just the first step. What Microsoft eventually hopes will emerge is a new kind of operating system, in which Windows gets spread throughout the Internet, just as the current Windows is in every nook and cranny of your computer's hard drive. Microsoft isn't being quite this explicit about its plans. But, as Ballmer put it the day of the announcement, "I just want to emphasize how grand we think the opportunity is."

Now, Ballmer and Gates say, Windows will start to go almost everywhere, not only inside machines of all kinds that are connected to the Internet--anything from PCs to smart toasters--but into the connections between them. The platform for writing computer applications will swell up from the desktop and the server into an Internet-wide service with the ungainly name Next Generation Windows Services--NGWS for short.

So Windows as we know it will not disappear. Far from it. It's just being expanded, and rehung in a new frame. Microsoft has just finished a gargantuan, five-year struggle to overhaul the company's most important product--the operating system for business called Windows 2000, which until now has been called Windows NT. The company will start shipping it, with great fanfare, on Feb. 17. Windows 2000 is the fuel that will keep Microsoft's profit engine revving. As Windows NT, it has been the software foundation of thousands of businesses around the world. As Windows 2000, it is enormously beefed up. The goal is to make Microsoft more competitive with the Unix computer companies, like Sun Microsystems and IBM, that still dominate the central computer infrastructure of large organizations. For example, Windows 2000 does a far better job than NT as the backbone of big corporate Websites. BarnesandNoble.com and Buy.com are two prominent sites that are starting to use the prerelease version. Windows 2000 is much more reliable--meaning it crashes less--and more scalable, so that multiple processors can be connected to build more powerful computers as a customer's needs change, and tasks can be shared among multiple machines. Says operating systems boss Jim Allchin, slapping his hand on the table: "This thing will become the standard in business. I can't say how long, but we are committed down this path."

Replacing Sun and IBM as the software vendor that FORTUNE 500 corporations entrust with their most mission-critical applications will be difficult. Explains John McKinley, chief technology officer at Merrill Lynch: "In our industry this is an all-out attack on one of the biggest strongholds for Sun--the capital markets trading arena. But the 'ship and fix' mindset that desktop software vendors have utilized doesn't hack it for mission-critical applications." So McKinley is taking a wait-and-see attitude toward Windows 2000. Winning over the likes of McKinley is crucial: Microsoft must make its way into the heart of corporate America in order to have the broad base it needs to implement its grand strategy.

Gates says that changing course now is similar to the situation Microsoft faced back in 1995. With Windows 95 finally finished, he says, "we put our heads up and said, 'Wow--Internet!' " The company realigned itself with astonishing speed and quickly became a major player in Internet software, squashing Netscape in the process. Now that Windows 2000 is finished, massive resources, mostly in the form of top-rank programmers, have been freed up. Their new task: Windows everywhere on the Net, starting with NGWS.

Explaining that this is in some ways a natural evolution of Windows, the Microsoft spinmeisters claim that Windows isn't really the desktop operating system the rest of us always thought it was. Says Allchin: "Windows is not some static thing. It's very dynamic. It's a brand, but as a technology it's continuing to change and evolve." Ask Ballmer about Windows, and he speaks very broadly: "The basic goal of Microsoft Windows is to provide the fundamental system services for user interface, programming, etc., that people are going to need to write applications to take advantage of the full power of the computing and communications world. That's how I define it."

So what kind of grand vision can we expect Gates to deliver? At this stage it's hard to say, but let's start with the operating system. Microsoft wants the OS platform to evolve off the desktop and into what it calls the Internet "cloud." This means that, just as software programmers from any number of companies now know they can write applications to work with Windows, in the future they will write programs that work with NGWS. Those programs will be able to utilize multiple resources across the full span of the Internet, just as a corporate application today might call on data in multiple servers on the company's internal network. (Of course, this "vision" of an operating system that extends over all kinds of networks, including the Internet, does sound a lot like Sun's decade-old credo: "The network is the computer." Others who have pushed closely related ideas over the past few years include Cisco, Novell, and Apple.)

Gates explains that the biggest change users will see is in the nature of the graphic interface. "Today you have a dichotomy between what a classic Windows application looks like and what a Website looks like," he says. "But why should there be that dichotomy? Why should I have to think about different search commands or different file systems?"

At the press conference announcing his appointment as CEO, Ballmer took a crack at explaining the range of stuff you might see and do through this unified interface. "There will be a day when you're able to keep all of your medical information in a secure, private place out on the Web. You'll be able to give permission to appropriate doctors to put new information in and to view your medical history. You'll be able to pay your bills, interact with your health-care insurer, receive notification when an appointment is necessary, and incorporate those appointments automatically into your calendar."

That's just one example, and it sounds like a service we'd all want. But once again the idea did not originate at Microsoft. Any number of vendors, ranging from big corporate software developers like PeopleSoft and SAP to a plethora of dot-com startups, promise users unified views of all their data and applications, whether the stuff resides on the corporate network or on the public Net.

Coming from a company currently defending itself against antitrust allegations, the implications of this vision are surprisingly broad. It almost sounds like Microsoft wants Windows to become the Internet. The company's executives bristle at the suggestion. Instead, they say their platform will enable other developers to better participate in the Internet revolution--although so far they come up short on details of how that might work. Still, insists Ballmer: "If with this NGWS thing we don't create far, far, far more great opportunities for others than we do for ourselves--as great as I think they will be--I would say we had failed."

That's not to say that Microsoft won't create its own services to take advantage of the NGWS platform. Says Jeff Raikes, who has Ballmer's old job as head of sales and marketing: "We'll end up doing some of our own services in order to show what's possible, just as we built Word. One benefit of that was showing what was possible with graphical user interfaces on Windows."

A tiny step in the new direction is already visible. Microsoft has begun to offer a service to deliver software over the Web. Microsoft Office Online was launched as a pilot late last year with a few telecom partners, including British Telecom and Digex. The software resides on servers hosted by companies known as ASPs (application service providers); software fixes and minor upgrades can be delivered directly to a user's computer, without his having to purchase and install a brand-new version. Customer interest is not overwhelming so far. But Bob Muglia, who oversees all Office products, is optimistic: "In the long term it can be a very positive thing, because it establishes an ongoing daily relationship with the customer." That's something Microsoft has long sought for its core products. It also could smooth out Microsoft's revenue stream, making today's highly trumpeted new versions of software irrelevant. And Muglia believes that customers might pay more for applications they know will continually be state-of-the-art.

Software as a service is still evolving; indeed, the most prominent software "service" Microsoft now runs is the Microsoft Network (MSN), a competitor of America Online. Longtime Hewlett-Packard veteran Rick Belluzzo left the CEO job at Silicon Graphics to head the consumer division last summer. He has streamlined and redesigned MSN and signed major new distribution deals with electronics retailers Best Buy and Radio Shack to promote MSN heavily in their stores. Now he's launching what he says will be by far the largest promotional effort for the service ever. "This new platform is something we intend to build more and more of our services on. So in some ways you'll see a tighter coupling of our activities with Microsoft at large," says Belluzzo. "We really want to become the consumer franchise of the Information Age."

That's quite a stretch. After all, MSN has just three million paying customers vs. AOL's 21 million. But as Belluzzo aggressively markets MSN to try to close the gap, the "collision" with AOL will quickly become evident. Pulling out a tried-and-true Microsoft tactic, Belluzzo will use price as a weapon. Today both services charge their customers $21.95 a month for access. But as Belluzzo points out, for many Internet users, "access is already getting pretty close to free." Belluzzo gives $400 rebates to customers who sign up for three years, effectively reducing their price to about $11 per month. (AOL's CompuServe online service has a similar rebate.) And unlike AOL, which is built on its own proprietary software, MSN is a genuine Internet software service, says Belluzzo. "Our strategy is a true Web infrastructure environment. AOL is a walled environment. They're kind of running counterforce to the Web's explosion of opportunity. They will be under constant pressure as people become more at ease with the Web."

Building up MSN does not mean building up content. Don't look for Microsoft to go after a content company to match up with AOL Time Warner. Says Gates: "We're not on the same strategy. We're not sitting here saying, 'When are we going to call them up to tell them about [buying] Disney?' " Here again, Microsoft will argue that AOL is more a closed shop, likely to give preferential treatment to its own content. "We could go to the other content providers," says Allchin, "and say, 'Hey, we're not doing that.'"

The irony of all this talk of openness, of course, is that to pull off his grand strategy Gates must integrate virtually every aspect of his company's products into one seamless, Internet-based offering. The kinds of "Web programs" the company says it wants to make could extend all the way from the inner guts of a corporate customer's data centers to user devices like MP3 music players or cell phones. To make that work, Microsoft must draw on everything from MSN to its most robust corporate applications. Such integration could make it that much more difficult to arrive at a settlement with the Department of Justice. Says Gates: "It's going to take all the energies of the company--the MSN expertise, the Office expertise, the Windows expertise, and the research group--to try to pull this off. So it's kind of outrageous to say...that the government would act to make it impossible for us to pursue that dream."

Whether the antitrust woes become Ballmer's headache or Gates' is unclear--and probably unimportant. The fact is that, despite Gates' title change, the two men will continue to run the unwieldy company as partners. Says Ballmer: "Bill has an amazing personal capacity...to keep a lot of things in his head and be the point of integration. But I don't think either Bill or I is up to this company, at this level, at this scale. It can't all be in one person's head."

Gates says he has spent more hours discussing technical strategy in the last three months than in any two-year period in Microsoft's history. He gives an example of his new responsibilities: "There are five different groups who each see a different piece of the user interface we're doing. I'm going to work with those smart guys and pick a single version. I want to keep them all happy and use the good parts of each one, but that's going to take time."

Practically speaking, Ballmer's responsibilities will not change much. Says David Readerman, Microsoft analyst at securities firm Thomas Weisel Partners: "Steve has been much of what has made Microsoft Microsoft for many years." Ballmer is known for loud outbursts and slamming his fists on tables and walls for emphasis, but what most distinguishes him as a manager is his fearlessness. Asked if he wasn't a little scared taking over the world's most highly valued company, he answered, "No, only because I don't let myself do that kind of thing in life. Mostly I just say okay, there's something I've got to do. Don't think about that. If you think about that you get scared, so don't."

For now, the clearest change in management will occur at the level below Gates and Ballmer. During the last year, the company has been restructured into four units: Belluzzo's consumer unit, including MSN, WebTV, Expedia, and MSNBC; a unit serving "knowledge workers," which develops Microsoft Office and all its component applications, and is led by Muglia; a software developer unit for Microsoft's programming tools and database, under Paul Maritz; and Allchin's operating systems group.

They are Steve's guys. Belluzzo, for example, came to Microsoft because Ballmer, who had known him for 14 years, called him. Though all the execs get along fine with Gates, several top managers known for being especially close to him have left recently, including CFO Greg Maffei, who took a job in December as head of a telecommunications firm, and chief technology officer Nathan Myhrvold, currently on a one-year leave of absence.

Whether this means that Ballmer now has the final say on key matters is an open question. When one reporter asked the new CEO who was going to call the shots in deciding about the Justice Department suit, the answer was hardly definitive. "We've agreed I'm on point," Ballmer said, "but Bill's clearly a member of our senior staff and has history not only with this case but with these kinds of issues. But there's no way to possibly resolve this thing without our top five, six, seven guys all brainstorming, understanding, etc."

Ballmer shares one conviction with Gates: He has no intention of letting Microsoft's centrality in the computing world diminish. Ask him if he thinks Microsoft will have as ubiquitous a role among users of technology in the new world of Internet-driven services as it does today, and he replies: "The process of working with ideas, knowledge, communication--I think that's big, big, big, big--BIG! And I don't want to cede that position." There's one other thing that's big, big, big--the new Microsoft vision, the BIG story that Ballmer and Gates are now telling. It may be years before we know whether it's fact or fiction.