Clash of the Free E-Mail Titans

March 1, 2002

When Microsoft bought Hotmail in a stock swap valued at $400 million four years ago, it got quite a bit more than it bargained for. Its plan was to make the deal pay by selling ads on the free e-mail service — and by eventually converting Hotmail's 8.5 million customers to Microsoft products. The strategy has succeeded spectacularly in one respect: Hotmail has more customers than ever — 110 million.

Only problem is, it costs Microsoft about $1 per year to maintain each mailbox. And with advertising in the doldrums across virtually every medium, Hotmail's ad revenues cover a mere 20% of the cost, estimates Safa Rashtchy, an analyst at U.S. Bancorp Piper Jaffray. So now, Microsoft is revising its approach. It's trying to attract nonadvertising revenues with subscription features that can support its system.

For most corporations, taming the e-mail monster means figuring out how to manage an onslaught of online missives. But the big mailers, such as Microsoft (MSFT ) and Yahoo! (YHOO ) face a different challenge: how to send the flood of e-mail without losing a bundle.

AN E-POSTAL SERVICE? The problem is most severe for small e-mail operations with poor economies of scale. Analysts speculate that it costs operators such as Terra Lycos and Mail.com, a unit of Net2Phone, as much as 5 cents to 6 cents to send each message, vs. much less than a penny for Hotmail.

It isn't hard to imagine what will happen once companies feel the full impact of this financial equation: The marginal outfits will drop out, while the biggest players will whittle down the range of free services they offer. That might ultimately lead to an online version of the U.S. Postal Service, where service is subsidized, but customers end up carrying some or much of the cost.

Even as a money-loser, e-mail accounts can be of great value to a online business. E-mail has always been one of the major attractions for subscribers to AOL. And Yahoo! Mail drives 80% of the traffic the Yahoo portal receives, estimates Jeff Fieler, global and consumer Internet analyst at Bear Stearns. He adds that many people who come to the site to check their e-mail end up looking at stock quotes and news, and doing searches. So indirectly, mail supports advertising on the wider site, which accounted for most of Yahoo's $189 million in fourth-quarter revenue. The same goes for Yahoo's e-commerce revenue.

CALL TO ARMS. Still, as a stand-alone business Yahoo! Mail is a huge money loser. U.S. Bancorp's Rashtchy estimates that it, too, attracts only enough revenue to cover 20% of its costs. Moreover, its value as "a loss leader at the supermarket," as O'Brien puts it, has diminished as ad revenues have declined. Thanks to the dot-com meltdown's effect on advertising, Yahoo's total revenues plunged 35% in 2001, to $717 million — and analysts aren't expecting much of a rebound this year.

To their credit, e-mail service providers have taken the bad news as a call to arms. One approach that's generating new revenues is distributing specialized newsletters, which many free e-mail users tend to sign up for. Microsoft's Hotmail offers about two dozen of them from its business partners, focused on everything from gardening to computer hardware. Thus, a user who signs up for a daily horoscope can find it paired with offers for psychic readings (initially, free).

The big mailers have also begun to sell value-added services, such as extra storage space for e-mail that their customers consider too dear to delete. In December, Microsoft started offering 10 megabytes of extra storage to its Hotmail users on top of the 2 megabytes they get for free — plus enough capacity on Microsoft's servers to set up their own Web page — for $19.95 a year. "We've been thrilled with the success," enthuses Sarah Lefko, lead product manager for MSN, of which Hotmail is a component. Analysts believe that about 300,000 users have signed up so far for the service, a number they expect to rise.

PREMIUM SERVICES. In fact, some providers are trying to speed this conversion by shrinking the amount of free space they offer. Yahoo! Mail cut storage per user from 6 megabytes to 4 megabytes in late 2001. (The new cap affects only new users.) But even long-time customers who like to send and receive digital photos and sound files, both of which take up large amounts of mailbox space, may be willing to pay $19.95 a year for an extra 25 megabytes of storage. Other new premium services include a personalized e-mail address domain for $35 a year and Yahoo! by Phone, which lets account holders listen to their mail via phone. Initially free, Yahoo began charging $4.95 monthly for it at the end of last year.

Smaller service providers are trying new strategies, too. PC-to-phone calling service Net2Phone, which has 3 million free e-mail accounts at its Mail.com site, plans to offer the option of an ads-free site within the next month for about $19.95 a year. Net2Phone is already charging $19.95 anually for automatic e-mail forwarding, plus $39.95 a year for customers who want to reach their Mail.com accounts using the Microsoft Outlook or Eudora e-mail programs. "We've been pretty happy with the response from users," says Keith Dallara, product manager for Mail.com, who nonetheless declines to provide specifics.

These providers' options are limited if charging doesn't work. AltaVista announced on Feb. 19 that it will soon discontinue its e-mail service and focus instead on its search and software businesses. Compared with those, e-mail isn't crucial, says AltaVista CEO Jim Barnett. The company never enjoyed the scale needed to run an effective service, since less than 0.5% of Alta Vista's 50 million unique visitors used its e-mail each month.

VIRTUAL MAILBOX. It's unlikely that Yahoo or Microsoft will leave the business — or even convert to all-paid services. For one thing, Microsoft has more than enough cash to absorb any losses at Hotmail. And besides, it has a bigger game in mind. Hotmail will be an integral part of Microsoft's Passport strategy, which is aimed at making Microsoft and its .NET (pronounced dot-net) set of software tools the wiring for transactions on the Internet.

At the center of the .NET idea is a virtual mailbox that would deliver messages and documents to any device, anytime, any place — and at last bring Microsoft the online success of its archrival, AOL. Free e-mail is "an important stake in the ground for future fee-based services," says Matt Rosoff, an anlayst with research firm Directions on Microsoft in Kirkland, Wash.

Eventually, most analysts agree, e-mail will make a profit and support itself, especially once advertising bounces back — and if the big mail providers make a fee more palatable by keeping spammers and pornographers out of their systems. "It will be one of the last Web businesses to make money," but it will get there, predicts U.S. Bancorp's Rashtchy. By then, though, only a couple of competitors may be left — almost certainly Yahoo and Microsoft. What until now has been a free lunch may look more like a free appetizer.