(FORTUNE Magazine) – It rained a little in Seattle on June 6, the day Judge Thomas Penfield Jackson issued his historic order to split Microsoft in two. And the 19,000 people who work at Microsoft's sprangly campus in nearby Redmond paid attention to the case--a little. A smattering of them gathered around the TV in the four-story atrium of the building that houses the Microsoft Network (MSN) to watch pundits chew over the news, but they probably would have been more enthralled by a Supersonics basketball game. Judge Jackson's ruling was kind of like the rain that perpetually sops Seattle: annoying and predictable, but so what?

The truth is, as grave as the legal problems are, Microsoft people--especially big shots like Bill Gates and Steve Ballmer--have other things on their minds. Revenue growth at the $20-billion-a-year granddaddy of software growth stocks appears to be flagging, especially in the company's core operating-systems business. Finally shipping the long-delayed Windows 2000 server operating system earlier this year did not light up the financial scoreboard at Microsoft in the same way that launching Windows 98 and Windows 95 did. Securities analysts have cut revenue forecasts for both fiscal 2000 (ending June 30) and 2001 by $1 billion or more. And between early spring and late June, the stock lost more than a third of its value, dipping as low as $61 a share. That has hurt morale among at least some of Microsoft's troops and may help explain the growing exodus of noteworthy employees (see the following story, "I Remember Microsoft").

You want problems? These are problems. The antitrust case, on the other hand, is a big "We'll see," and Gates can't afford to await the outcome. He has to act now.

And so he has, with a bold, bet-the-company gambit that he and CEO Steve Ballmer unveiled in a four-hour marathon announcement on June 22. Chairman Bill thinks it is just the remedy for what ails Microsoft: a daring and frenetically unfolding technology and business strategy to revamp the very way the Internet works. It's a plan that promises not only to change how companies and individuals use the Web but also to transform Microsoft in ways that even a government-imposed dismemberment could not. And it's a plan on Bill Gates' terms, one that completely ignores the prospect of a court-ordered breakup. Keep that point in mind: Beyond this shoot-the-moon strategy, there is no Plan B.

It's also a very complicated plan, one we'll lay out in greater detail later. For now, suffice it to say that Gates hopes to make the new initiative's name, Microsoft.NET, as ubiquitous as "Windows." To do so, Microsoft will offer not a product delivered on a CD-ROM in a shrink-wrapped box, but many layers of software that it hopes ultimately will be ingrained in literally billions of servers, PCs, cell phones, handheld computers, TV set-top boxes, and sundry other devices. The purpose: to enable the hordes of computers that store and dish up Internet Websites to present their data in a universally understandable form, so that information drawn from unrelated sites anywhere in the world can be spontaneously synthesized into interactive pages--what Bill now calls "webservices"--tailor-made for any individual, no matter what digital device he or she happens to be using.

If Microsoft succeeds, the Web will be more useful than ever. Consumers would be able to manage all their finances in a single window on a browser, to give just one example. For companies, meanwhile, Microsoft.NET could unleash the power of Internet business-to-business exchanges and e-commerce in ways that could give new meaning to the words "efficient markets."

Yup, this is the most ambitious plan Microsoft has ever pursued, and Gates and Ballmer know it. "This is the future," Ballmer says. "It's the big kahuna."

Such swagger has invigorated Microsoft in the past. "Microsoft always works best when it's on a jihad," says group vice president Jeff Raikes, a 19-year Microsoft veteran who has pretty much seen it all. "And this is the next jihad. But what's different this time is it isn't just about developing the technology and reshaping the Internet. It's about redefining our company too."

Redefining a company is never easy, of course, and Microsoft's planned reinvention will be more difficult than most. Start with the fact that to champion XML, the technology that underlies Microsoft.NET, Microsoft will have to behave like the opposite of a monopolist. It will have to win the cooperation of Website operators, corporations, and infotech and telecom hardware and software providers, including archrivals like IBM, Oracle, and Sun Microsystems. For XML to work, the entire industry must agree to make it the basis for storing and shipping data on the Web. Indeed, Microsoft has already joined a consortium developing rules for XML--a veiled acknowledgment by Gates that Microsoft can't dominate the networked world simply by fiat as it did the world of the PC.

More unsettling yet is that Gates and his top execs aren't exactly sure how Microsoft.NET will generate sales and profits. That's right: Microsoft is embarking on this massive plan without being sure of its business model. Says group vice president Paul Maritz, a quietly brilliant engineer from Zimbabwe who more than anyone but "chief software architect" Gates is responsible for Microsoft.NET: "We don't know precisely whether we'll get paid for everything." Those are astounding words coming from a top executive at a company where revenues have flowed in a fabulously profitable and predictable way for years. But Maritz is telling the truth. Packaged software and corporate licensing of applications now account for the bulk of Microsoft's revenues and profits; if Microsoft.NET succeeds, the way consumers and corporations pay for software will be transformed. Bet the company indeed.

During the weeks before its June 22 announcement, Microsoft gave me exclusive access to senior executives, including Gates, Ballmer, and all their top lieutenants. In one interview after another, it became clear that Microsoft.NET is very much a strategy-in-progress. But it also became clear that it has galvanized the company as nothing else has recently, not even the Dec. 7, 1995, initiative in which Gates steered the company toward the Internet and effectively placed a fatwa on the head of Netscape. After all the embarrassments of the trial--Gates' video deposition, the poor performance of Microsoft's lawyers, the loss of one ruling after another--focusing on something as ambitious as Microsoft.NET is a huge relief. It marks a return to the company's brash roots because it puts programming front and center, and because it poses a huge intellectual challenge.

Pacing his office during our interview, a weary-looking Gates insisted that the Microsoft.NET strategy has everything to do with technological opportunity; the antitrust case has no bearing on it at all. Yet Bill wouldn't be Bill if there weren't a note of defiance in his plans. "We want the support of everybody. But it's not like we're passing around a collection basket here. This is what we are going to do. We have the money in the bank to go do exactly the stuff that we want. We're putting 100% of our energy behind this because it's our destiny and it fits in with what our expertise is and what we like to do."

Bill Gates' genius has always been his ability to spot technology trends early and then to amplify them into must-have products that shape entire industries. Back in 1975 he and Microsoft co-founder Paul Allen were as quick as anyone to recognize the significance of the microprocessor chip and its potential for fostering a bigtime software industry. Gates also was among the first to perceive the importance of industry standards, parlaying the MS-DOS operating system into the key building block for today's $200-billion-a-year PC industry. And even when he isn't the first to sense the promise of a key technology, nobody is better at marshaling resources to exploit and market it: to wit, the graphical user interface embodied by Windows and, more recently, the browser embodied by Internet Explorer.

With Microsoft.NET, Bill is doing it again. He's betting that XML, which programmers all over the world have been quietly developing for years, is the next big thing. Short for Extensible Markup Language, XML is the result of programmers' collective effort to add new powers to the World Wide Web. Simply put, it is a standardized way of storing raw data--text, spreadsheet numbers, pricing lists, employee records, you name it--so that every number or passage of text carries a little extra information to make it readily identifiable by just about any machine. These "structured data" can be imported and instantly manipulated by software programs and devices that had nothing to do with creating them in the first place.

Think of XML as a bar code for information. It promises to transform the Web in two key ways. First, it would let surfers excerpt text or numerical tables directly from a Web page, paste them into a word-processing or spreadsheet application on a PC, and then edit or annotate the text or manipulate the numbers. (Today, when you cut and paste from a Website, text loses its formatting and spreadsheets become as impossible to manipulate as the contents of a fax.)

Second, XML would be a lingua franca that would enable software companies, corporate programmers, and Web developers to design "webservices" that could summon specific information or transaction capabilities from one or more sites and synthesize them into a customized Web page.

All this sounds awfully arcane, but as a couple of examples make clear, it is a very big deal. Let's start with what it means for consumers. Once Microsoft.NET infiltrates the Internet--look for this stuff to start rolling out early next year--you will be able to use your PC (or your digital cell phone or digital TV or wireless handheld PDA) to ask the network to pull together a consolidated statement of all your financial accounts at various unrelated banks, credit-card companies, and brokerages. Voila, within seconds a neat table that even totals everything up, formatted to make sense no matter which device you're using (see diagram). With a few keystrokes or perhaps a voice command, you could, say, instantly transfer money from your Schwab brokerage account to your Chase checking account. You could even order the Internet to automatically make cash transfers between institutions on your behalf whenever your checking account drops below a certain balance. Thus you may, for the first time, actually succeed in getting your arms around your family finances--all thanks to the Internet, enhanced according to Bill.

The implications for businesses using the Net are just as large. The hottest trend in B2B e-commerce is the emergence of exchanges that facilitate transactions between companies within a given industry. XML could vastly simplify building such exchanges because it can render each participant's inventory and pricing data universally comprehensible by all the others, making transactions a snap. Utility.com is an exchange in Albany, Calif., that helps electric utilities share excess capacity. "The biggest single barrier to our ability to offer competitively priced electricity is the cost, complexity, and reliability of data exchange," says CEO Chris King. "With XML, we're there."

This upgraded Internet is what Gates is counting on to reignite Microsoft's business. But harnessing it is a challenge that you would have to describe as macrosoft-size. Bill's game plan is built around a page taken out of Microsoft's original playbook. The company's very first product was a software tool that Gates himself wrote--a version of the programming language Basic. Early geeks used the product to cobble together games of ticktacktoe on primitive microcomputers, and it won Microsoft the loyalty of an entire generation of programmers. The linchpin for Microsoft.NET is likewise a software development tool. Dubbed Visual Studio.NET, it will ship in trial "beta" form this fall. When it's released for real, early next year, it could win Microsoft a whole new generation of fans.

Though software tools are far from Microsoft's biggest or most lucrative business--they generated just $600 million in revenue this year--legions of programmers at software companies, large corporations, and dot-coms depend on Microsoft's versions of the programming languages Basic and C. The new Visual Studio.NET is designed to build on that vital base. What makes Visual Studio.NET so important is that with a few clicks of the mouse, a user can automatically take a finished program written in Basic, C, Java, or dozens of languages created by other companies and "XML-ize" it. Result: Any data the program generates are stored and made available in the new Internet-friendly format. Gates is hoping that those legions of programmers will quickly adopt Visual Studio.NET and start seeding the Internet with sites and services that offer XML-ized data.

Microsoft isn't the only company promoting XML. Indeed, one of the most interesting wrinkles in the Microsoft.NET strategy is that Microsoft has opted not to try to create a proprietary version of XML that it could sell at a huge profit. Instead, the company is working closely with IBM and an industry-standards body called the World Wide Web Consortium, which has the support of Sun, Oracle, Hewlett-Packard, Apple, and more than 400 other companies, to hammer out a version of XML they all can live with. "I told Bill I thought it was the single most courageous thing he's ever done," says Dave Winer, founder and president of Userland, a small Silicon Valley software-tools company that is a key player in determining XML standards. Winer thinks the cooperation will discourage predatory behavior: "IBM and Microsoft and Sun will keep each other honest," he says.

"Yeah, yeah, yeah, so where's the payoff for Microsoft?" you ask. Hidden right here. It will come as Microsoft's programmers use Visual Studio.NET to revamp its mainstay product lines. Take operating systems, the hugely profitable, $8.5-billion-a-year business whose growth has been slowing. Microsoft's techies are racing to retrofit Windows in ways that will make both servers and desktop PCs adept at handling XML-based webservices and at serving up data to whatever type of device might be tapping in, be it a cell phone, a pocket organizer, a TV set-top box, or a PC. Gates is betting that as the world's programmers become enthusiastic about Visual Studio.NET, they will find that their programs run best on Windows servers and Windows desktop PCs. That will accelerate demand for the operating-system products, which in turn will also hasten the spread of webservices, which in turn will cause business to boom...you get the picture. Says Mich Mathews, vice president for marketing: "The idea of XML and webservices is really viral. Already it has really helped us think of our company in a new way, and it will help our customers think of the Internet--and Microsoft--in a new way too. We believe that if we build it, they will come."

That's the theory, at least, and it is driving software development throughout the company. Microsoft is racing to XML-ize virtually all its products. This gives MSN, the company's woebegone, less-than-$500-million-a-year Internet portal and ISP unit, a new mission. For most of its five years of existence, MSN has been a disappointment, lurching from one strategy to another. It has yet to earn a profit. But now Microsoft is using MSN to show off webservices that illustrate how the next-generation Internet will actually look and feel. One, called Passport, acts as your online ID card. It remembers all your user names and passwords for your Internet accounts and e-commerce sites and submits them automatically when you visit. Another is MSN's shopping service, whose member stores already use XML data in their online catalogs. This enables any Web surfer to comparison-shop for a particular item on a single, spontaneously generated Web page. MSN also offers a glimpse of the way the browser user interface will likely change as webservices become the norm.

"We're the pioneer of consumer webservices at Microsoft and are giving the rest of the company lots of feedback about what works and what doesn't," says Brad Chase, the senior vice president in charge of MSN. "We're also working with partners to help them roll out webservices. Because we're dealing with literally tens of millions of users, we figure that if we can make webservices work for consumers here, Microsoft can do it for businesses."

Another beneficiary of the Microsoft.NET strategy is the company's new wireless division. In particular, it demonstrates how serious Microsoft is about working with partners. Paul Gross, the senior vice president in charge, explains: "We have no desire to become a wireless provider. Our focus is giving the world's 48 major wireless carriers a server infrastructure that they can plug right in to their networks to deliver traditional enterprise applications and new webservices to their subscribers' cell phones and other wireless devices." Microsoft also plans to sell the wireless companies standardized webservices to help with online user identification and e-commerce transactions, so the carriers won't have to write their own software to handle those jobs.

And what about traditional productivity applications like those in Microsoft Office? Microsoft expects XML to greatly change that $8.8-billion-a-year business. At its four-hour press event in June, Microsoft showed off an early prototype of something it calls Office.NET. Office.NET users won't have a big copy of Word or Excel on their hard drives. Instead they'll use their mouse to tap into versions of those programs on a server. Since the server can handle much more than a mere PC, the application will be loaded up with e-mail, calendars, instant messaging, and collaborative document annotation. Result: Office on steroids, an application that truly does have everything you could possibly need at your desk. Microsoft concedes that not everyone will want to trade in a personal copy of Office for something that sits on a server, but thinks that in many companies the communal approach will catch on. "[Office.NET] will make sense in organizations that use the Internet as their primary means of communication," says group vice president Bob Muglia. "You'll see people using something like [Office.NET] to hold virtual meetings or to build collaborative documents that are shared and annotated online rather than on paper."

Sure, this is an exciting and ambitious vision. But the overall business implications for Microsoft are hugely unsettling. Once you get past sales of the newly souped-up versions of Windows and Visual Studio.NET, Gates and his lieutenants aren't exactly sure how the money is supposed to work. Group VP Raikes thinks applications software like Microsoft Office will morph into Web services to which people will subscribe. He's eager to embrace such change, he says: "As software becomes a service, there will be tremendous opportunities to create wealth. It's not just that the transition to subscription-like services creates a more stable, recurring revenue stream, but it also brings us closer to our customers. We'll constantly be maintaining and improving these services for them. And if we do it well, that should lead to more business."

Confident that the money will roll in down the road, Gates and Ballmer seem less concerned with solving the mystery of the webservices business model than with the thorny cultural problems the strategy creates. Microsoft.NET will require better orchestration of the company's development groups than Microsoft has ever achieved. Given Microsoft's reputation as a superefficient killer of competitors, you might assume that the company's operating systems, programming tools, business productivity applications, and MSN units always mesh like clockwork. But the truth, says Winer of Userland, is that the groups "fight with each other and hold each other back much of the time. I know, because I've been caught in the crossfire."

Microsoft.NET, admits Gates, "is an organizational challenge, no question. It's pushing the boundaries between various groups. But if you want the plane to fly, you can't have the people who are building the wings not talk to those building the engines. Steve has to figure out how to make the groups see each other as synergistic or overlapping." How will Ballmer do that? "You can't just reorganize the company to make something like this happen," says Ballmer. "Anyway, we've probably had too many reorganizations around here. So it's really a question of remissioning people rather than reorganizing them. Does that make sense?"

The need to showcase Microsoft's new webservices thrusts MSN into direct contact with software-development teams all over the company, for example. The operating-systems group helps MSN tune its servers and scale up webservices to support 2.7 million ISP subscribers and 40 million online visitors a month. The business productivity group, which develops the Internet Explorer browser, has pitched in to develop a specialized Internet browser, code-named Mars, strictly for MSN users. It will provide one-click access to e-mail, calendar, and shopping webservices. Assistance from the wireless group was crucial in putting together MSN's nascent service to deliver e-mail and news to cell phones.

All that collaboration may or may not give MSN enough unique features to let it step out from the shadows of the dominant Internet portals, AOL and Yahoo. But the new mission has already accomplished something big within Microsoft: It has helped the unit shed its image as the Rodney Dangerfield of the company's many businesses.

While Gates and Ballmer seem sure that Microsoft will execute their grand strategy as brilliantly as ever, the details are far from being worked out. As Ballmer puts it: "The last big memo we put out about this is already out of date." And Gates concedes, "There are some of these pieces that we're still working on exactly how they schedule out over the next two years."

But with all these threads, isn't there real potential for something to go wrong? To begin with, the strategy is so amorphous, arcane, and couched in hypothetical examples that the public, Wall Street, and Microsoft's customers may struggle to grasp it. I interviewed people inside the company before the Microsoft.NET brand name was settled on, and practically every executive--including Gates and Ballmer--had difficulty explaining succinctly what the new strategy really was. Give them an hour and you began to get an idea, but even then I felt like one of the blind men feeling the elephant. No wonder the public announcement in June took four hours.

Nathan Myhrvold, the former chief technical officer who earlier this year retired to, among other things, spend more time on archaeological digs, says such inarticulateness is typical Microsoft. "One of the ugliest processes to watch at Microsoft is what they go through to figure out how to present a big idea to the public. But eventually they get it."

Another obstacle is the rapidly diversifying nature of the Internet itself, and not just in terms of the kinds of devices connected to it. Microsoft faces a plethora of rivals large and small that also want to deliver very sophisticated enterprise and e-commerce software or Internet services for consumers. For more than six months Hewlett-Packard has been touting "e-services" that aren't all that different from those that Microsoft describes. Competitors like IBM, Sun, Oracle, Yahoo, and AOL aren't standing still either. (Quips Bill Joy, chief scientist at Sun: "The real story here is that Microsoft is embracing Sun's strategy and IBM's strategy and Oracle's strategy.") Then there are the 424 members of the World Wide Web Consortium, the group that will establish the industry standard for XML. Even if only a fourth of them get serious about building XML-based services, that's still a lot of competition.

Nevertheless, Microsoft thinks it has an edge--its executives say it can build webservices that take particular advantage of its Windows operating systems and hence perform better. But any special enhancements Microsoft builds into Windows can be a double-edged sword, especially with big corporate customers whose computer infrastructures, like the Internet itself, mix many brands of hardware and software. They don't want services that won't work equally well on their Unix servers and Macintoshes.

The competitive pressure doesn't seem to bother Microsoft. "We're realistic," says Raikes. "In the Internet Age we can't expect the market-share ownership we've had in the past to continue. But if the whole pie grows fast enough, there will be plenty of room for us to grow too. And our strategy is all about making that whole pie grow."

There's one other obstacle that cuts right to the core of Microsoft's business--something people in the industry call "software fatigue." While there may be demand for new software bells and whistles like e-mail access for cell phones or more- capable Websites, corporations seem to be wearying of upgrading whole server systems. "Our big customers just went through that when they dealt with Y2K issues," says John Ryan, CEO of Entrust Technologies, a maker of security and ID authentication software in Plano, Texas, and a big proponent of XML. "It's no fun." So is the world ready for yet another massive change? After all, that is what Microsoft.NET entails.

That's why even the newly released Windows 2000 is a tough sell, says David Readerman, an investment banker and securities analyst who follows Microsoft for Thomas Weisel Partners in San Francisco: "The deployment cycle for Windows 2000 is very lengthy and sometimes painful because you invariably have to upgrade other software too. It's taken Microsoft itself 15 months just to upgrade its own 50,000 PCs to that operating system, so you can imagine how long it might take others."

Gates contends that the XML-based webservices made possible by the Microsoft.NET strategy will so tantalize customers that they'll eagerly upgrade. Says he: "One thing people don't really appreciate is that because our installed base is fully paid for, our biggest business challenge is to revolutionize our installed base. If we [make only small improvements], then people say, 'Hey, is that your new version? So what!' It's like building a refrigerator that lasts forever. But this really is revolutionary."

Speaking of pitfalls, let's remember that Microsoft has that cloud of a court-ordered breakup looming over it. In what seems a high-stakes game of chicken, the Microsoft.NET strategy ignores that possibility. But that's not to say executives are oblivious or unconcerned. Without my having to ask or prod as I reported this story, Microsoft officials often blurted out cynical references to the antitrust case. While everyone expressed confidence that Microsoft would ultimately win on appeal, several said the company was "under siege" or "being hounded"; more than one called the situation "surreal." Bill Gates remarked during our interview, "Aren't you going to ask me some questions about the trial?"

Judge Jackson himself temporarily parted the clouds in late June by ordering a stay of the behavioral remedies he had imposed until a higher court reviews his findings and the proposed breakup plan. That has lifted morale and boosted Microsoft's stock price somewhat. More important, it means that most of the troops can ignore the distraction and concentrate for the next 12 to 18 months on turning Bill's Microsoft.NET strategy into reality.

Now, it's futile to handicap the likelihood that a breakup will occur, given that we don't even know yet whether it will be the Supreme Court or the Appeals Court for the District of Columbia that hears Microsoft's challenge. But just as a mental exercise, let's say that 18 months from now, Microsoft actually loses its appeal and is forced to split in two. How would the Microsoft.NET strategy, which would have had time to roll out by then, affect the two Baby Bills as they went their separate ways?

Pundits and analysts postulate that if Microsoft were split into an operating-systems company and an applications/Internet browser/MSN company today, the applications business would hold more potential for growth because it would contain Microsoft's most profitable products and most of its Internet assets. Meanwhile, prospects for the operating-systems business, whose growth has been slowing, are deemed a little less golden.

But that was before Bill and Steve unveiled Microsoft.NET. If XML takes off and webservices are the new order of the day, the relative prospects of the two Baby Bills could be reversed. Demand for servers and PCs that smartly handle XML could well surge, making the operating-systems company a star. Meanwhile, truly interactive XML-based webservices presented through your PC's browser might well supersede the need to have traditional word processors and spreadsheets onboard. So even though MSN might find a way to parlay webservices into profits, the applications company's crown jewel--Office productivity software--could see its market dwindle.

Regardless of what happens, three things are clear now that Gates has shown his hand. First, Microsoft isn't playing by the rules the Justice Department would have it obey--it's applying every bit of technological leverage throughout the company to influence as much of the infotech industry as it can.

Second, Gates & Co. aren't playing by the old rules that enabled Microsoft to become a monopoly either. Much of the Microsoft.NET strategy hinges on making XML a standard that the company's fiercest competitors also support rather than a proprietary technology to be used against them.

Which brings us to the third thing: Microsoft at last is playing by the rules of the Internet. A bigger change than that is hard to imagine.

REPORTER ASSOCIATE Alynda Wheat

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