Microsoft's mettle has been tested before, but in the next few years the company will face what are arguably its toughest challenges yet.

These include:

• Finding growth opportunities to offset the maturing of its operating system and Office businesses.
  
  

• Winning back the trust of customers fed up with security shortcomings and what they see as inflexible licensing schemes.
  
  

• Fending off stronger open source competitors as the company creates its next-generation platform, code-named Longhorn.
  
  

The world has changed since Microsoft went public in 1986. Gone are the days of 30% to 50% annual growth rates while chewing up competitors. Over the past three years, the company has averaged 11.5% revenue growth, and its stock price has only gone up 1% over the the past 52 weeks.

The company even issued its first-ever dividend to stockholders last year, a sure sign it is transforming from high-flying tech Titan to blue chip.

The transformation was reconfirmed at the company's annual financial analyst confab in July where annual new product demonstrations were replaced by staid assurances of "boosting the business value of software" and talk of revenue dips in fiscal 2004.

"The company is maturing and in general [CEO Steve] Ballmer and [Bill] Gates are a lot more careful," says David Smith, a vice president at Gartner. "They maintain an edge, but they have softened it a bit."

But Microsoft isn't softening as a technology powerhouse. It has $51 billion in cash and a $6.9 billion research-and-development budget focused on everything from servers to the XBox game system. Its client operating system and Office suite each own more than 93% of their markets; both maintained sky-high operating margins in the company's 2003 fiscal year, ended in June; and together they supplied 62% of revenue and 98% of profits.

Such numbers make old habits die hard, so not surprisingly, the company's growth plans are familiar. This was evidenced by a reorganization late last year that created the Windows Core Operating System Division, which will focus on development of the client and server operating system.

Microsoft is looking to capitalize on its desktop dominance and emerging server empire, which are core to a new generation of products under the Longhorn banner. The division will meld the contents of Microsoft's software portfolio, integrate it with other platforms on the back of XML, and, according to a recent report by Goldman Sachs, potentially initiate the largest upgrade cycle in the company's history.

"The simple summary is that we believe that we're just at the beginning of what we can do with software," Chairman and Chief Software Architect Bill Gates said in October.

Feeding the cash cows

Although Longhorn is the future, the technology is not expected to be generally available for at least two more years. In the interim, Microsoft must nurture its client operating system, its server operating system and Office businesses, the only three of Microsoft's seven business units turning a profit.

Revenue growth in its client operating system and Office businesses has been positive but anemic over the past couple of years, but the company projects single-digit declines for both business units in 2004 compared with 2003. Meanwhile, the company's Windows Server business might be hurtling toward the same crossroads.

On the client operating system side, the plan is to move existing users to newer systems and find new markets for its operating system. There are 350 million PCs running Windows NT or 9x that Microsoft wants to convert to Windows XP, a goal laid out by Jim Allchin, group vice president of the platforms group, in July. Many of those converts might be forced because Microsoft has ended or is about to end support for those legacy clients.

The company also hopes to put an operating system in other types of computers, including handhelds, tablet PCs and smart devices, and create multi-PC networked households that use the Media Center operating system as a hub, according to Allchin.

On the server operating system side, Microsoft owns almost 55% of the market, though isn't likely to grab more than another 10% overall, says Al Gillen, an analyst with IDC. He estimates that the overall server operating system market will show a compounded annual growth rate of 9.1% over the next five years, identical to that of 1997-2002.

"That is the sign of a maturing market," Gillen says.

Lately, SQL Server and Exchange have carried the load in Microsoft's Server and Tools business unit with double-digit revenue gains quarter by quarter. Microsoft, which increased head count in its server sales force by 12% last year, is building on that strength with Exchange 2003 and the planned release next year of SQL Server Yukon and Visual Studio. Net Whidbey development tools.

Longing for Longhorn

But the focus for 2004 is further development of Longhorn, Microsoft's "big bet on galvanizing the next big breakthrough - even bigger, perhaps, than the first-generation Windows release," according to a memo Ballmer sent to employees in June. The statement was backed up in October with the release of beta code more than two years before product shipment, the earliest Microsoft has ever let independent developers evaluate new code.

Longhorn's first incarnation is the client operating system, due in 2006, but Longhorn includes servers, development tools, Office and even MSN, the company's online property. Longhorn is designed not only to blur the lines between applications and data on desktops, servers and the Internet but eliminate them and make the systems look like one.

Longhorn has several key elements that support that effort, including Avalon, a presentation system for new applications; Indigo, an XML-based integration bus for clients and servers; WinFS, a platform-wide file system; and WinFX , a new set of APIs.

Those underpinnings grew out of Microsoft Research and were fueled by Microsoft's massive R&D spending, which topped $23 billion over the past five years.

The desire to create the Longhorn "fat client" is a direct attack on rivals such as IBM and Sun that want to break Microsoft's desktop stranglehold using Java Application Servers, portal interfaces and browser-based clients.

Longhorn also is intended to thwart Linux and open source. Microsoft wants to fight the upstarts with a collection of integrated software as opposed to individual features and price on the client or server.