By Ina Fried
Staff Writer, CNET News.com
April 26, 2006 4:00 AM PST

MOUNTAIN VIEW, Calif.--After an hour-long discussion at a status meeting last month, the Hotmail redesign really boiled down to one key decision: one big ad, or two?

After months of reworking the venerable Web mail program, Microsoft's team had made all the easy fixes: They'd added more colors and even offered a way to make the new Windows Live Mail look just like the old Hotmail.

But sitting around a table in the nondescript Pyre conference room in Microsoft's Silicon Valley offices, the half-dozen developers and managers couldn't avoid the thorny issue that remained. A significant number of people believed that the new design had too much space devoted to ads, making it hard to use some of the mail program's new features.

The ad placement decision may seem minor. But it's a key one for Microsoft, which is trying to turn Hotmail's hundreds of millions of casual e-mail users into customers for a wide variety of Windows Live personal services.

Offer too many ads and the company risks alienating users and sending them flocking to rival online services. But if it forsakes the second ad, it risks choking the revenue the business needs to compete with the likes of Yahoo and Google.

"Removing one of those ad products is a very costly thing," product planner Richard Sim told his colleagues during a meeting about the ad issue, among others. But in the end, everyone knew what had to be done. Painful as it was, they had to side with their users and hope the dollars would be there.

It's a big bet for Microsoft, which has spent the past two years overhauling Hotmail into what is now dubbed Windows Live Mail. After years of leaving the e-mail service largely on autopilot, Microsoft was jolted into action on April Fools' Day 2004, when Google launched Gmail, a Web-based e-mail service with a gigabyte of free storage. Since then, Microsoft has been racing to catch up.

Sara Radicati, who heads the analyst firm Radicati Group, said an overhaul is definitely needed.

"The Hotmail service has kind of lagged behind some of the others," Radicati said. By being early to the market with a free service, Hotmail for years found it easy to sign up more and more users. "Probably, they became a little bit complacent."

Even those inside the company generally agree that the launch of Gmail was a giant wake-up call.

"When Gmail came, it basically raised the bar on expectations and also capabilities of what is a modern Web browser application," said Richard Craddock, the development manager for Windows Live Mail, which is set for launch later this year.

Microsoft had been kicking around ideas on how to revamp Hotmail since at least 2002, but the ideas stayed on the drawing board until Gmail came around.

"It became very clear...this is what we should be doing,'" Craddock said. "Somewhere along the way, we realized there was probably a lot more money in this free e-mail service than we recognized before."

Off the back burner
Microsoft was early to spot the potential of free e-mail. Back in late 1997, it opted to spend hundreds of millions of dollars to buy Hotmail. But after that, the service remained essentially the same for a decade. Microsoft invested in more servers and additional data centers as the service grew, but Hotmail itself only saw modest, incremental changes.

Although the unit's product changed little, the company did manage to retain some key talent over the years.

Among these people was Reeves Little, who enjoyed the MacGyver-like charge that came from seeing what could be added to the nearly decade-old code. But prior designs required the software equivalent of bubble gum to stick on new features, Little said.

But when it came time for the redesign, code-named Kahuna, Microsoft knew it needed some new in-house blood to augment the Hotmail veterans. (Fewer than a dozen people remain from the original Hotmail team.)

One of the recruits was Mike Schackwitz, who had been working at Microsoft's Redmond, Wash., campus on Internet projects destined to become part of Windows Live. The group program manager said the job, based in Silicon Valley, had twin allures.

One was that Hotmail was the company's single-biggest Web asset. The other was the weather. "Frankly, it rains a lot in Seattle," he said.

A week after he accepted the job, Google launched Gmail. "There was a moment of, 'Oh, yes, this does really matter," Schackwitz said.

While Schackwitz may have been motivated by the California sun, others noticed his move and decided something interesting might be going on at Hotmail. Omar Shahine moved there from the Mac business unit and brought a half-dozen good people with him. Suddenly, stodgy old Hotmail was, well, hot.

By last July, the company had a revamped version ready for the outside world to get its first look. Gone were the check boxes beside each message. In their place, Windows Live Mail offered a layout not unlike that of Outlook, Microsoft's desktop e-mail that lets people preview messages before they are opened and move items by dragging and dropping them into folders.

Hard-core techies loved the new look, with its Outlook-like reading pane and advanced features, such as spell-check. But when the company expanded testing in January to include more of its run-of-the-mill Hotmail users, they hit a snag.

Some like it Hotmail
A significant number of testers liked the old version better. "There was this Hotmail loyalist that loved the check boxes," Schackwitz said.

As many as a fifth of the users in some test groups were opting to go back to the old version.

"It could have completely derailed the train," Schackwitz said.

Instead, Microsoft found a compromise. In its latest build, Microsoft decided to add back a "classic mode" option that essentially stripped away most of the new features. The classic mode uses the new architecture behind the scenes, but to consumers, it looks like the same old Hotmail.

But adding the classic interface was sort of a sore spot with some of the Hotmail team.

Product planner Sim likens the new experience to a hot tub. For some users, it was just too hot. With classic mode, he hopes longtime Hotmail users can dip in their toe and discover they like the new bubbles, without immediately taking the plunge. So far, plenty of Hotmail users are happy to stick with the warm bathtub afforded by the classic view.

"When they first dip their toe in, it's way too hot," Sim said. "They sort of have to slowly ease their way in."

For Microsoft, if not for all its users, it is definitely time to move forward. A big part of moving to Windows Live Mail is about trying to keep up with Microsoft's faster-moving rivals, the service's development team said.

Craddock said that before Microsoft started Windows Live Mail, it was "taking a fairly long time to do significant releases," noting that updates might take nine months or a year to arrive.

"Frankly, we didn't think we were smart enough to predict what people want a year in advance," Craddock said. Instead, Microsoft's new mantra is to get new ideas out quickly, see which ones stick and then make tweaks on the fly. "We changed the way we develop software. We now ship a new service to the site every eight weeks," he added.

That approach has brought to light some pitfalls--like the need for classic mode--and some unexpected successes. One big hit was the changeable color schemes that Microsoft added to recent test versions of Windows Live Mail.

"It was actually quite low on our list," Sim said. "The product team just really didn't see much value in it."

Users, on the other hand, felt quite differently. "I didn't realize how much I disliked the old one until I changed color schemes," one tester noted.

Consumer opinions can be very humbling, Sim said. "You feel like you've got...the best engineers building really world-class software," he said. "When you really begin to get user feedback on it, you begin to realize that some of the assumptions that you have were wrong."

Still, Sim is confident that Microsoft has got it right when it comes to the overall shift from Hotmail to Windows Live Mail.

Removing one of the big graphical ads from the in-box is just one step in an effort to create an e-mail service that people will want to use, Sim said. As it stands now, Microsoft plans to jettison the long skinny ad that runs along the side of the in-box in current test versions.

"A lot of it has to do with...users have grown accustomed to expect that you can scroll vertically," Sim said. Having to scroll horizontally is "more of a pain point."

To recoup some of the revenue from the lost ad, Microsoft is looking to sell advertising that would appear at the bottom of e-mail messages sent using the service. In the past, Microsoft has included its own promotional messages, but Microsoft has had talks with some big-name advertisers about buying that prime real estate.

But even as Microsoft seeks to reinvent Hotmail, its competitors forge ahead.

Since first announcing Gmail with 1GB of storage, Google has more than doubled the size of its mailboxes and worked to integrate Gmail with other services, such as instant messaging. Yahoo, meanwhile, has been testing a mail service update that adds an Outlook-like interface and other advanced features, such as the ability to have multiple e-mails open at the same time.

Microsoft, for its part, has an image problem to overcome, Radicati said.

With Gmail, Google managed to launch a service that is "sexy," Radicati said. Hotmail hasn't had anywhere near the same allure.

"Their image is just that they are free," she said.

Perception is important, Radicati said, since free Web e-mail accounts are largely a commodity business. People often sign up on a whim for a new account, but getting committed users is more of a challenge, she said.

In recognition, perhaps, of its diminished coolness, Microsoft is largely abandoning the Hotmail brand it spent so much to acquire--another big gamble. Existing members will be able to keep their Hotmail.com address, but new users will receive Live.com addresses, and Microsoft will stop using the venerable Hotmail brand to tout the service.

In its place, the mail unit is getting a piece of the Windows brand, something that top executives like CEO Steve Ballmer have made clear is a big responsibility.

"Ballmer reminds us of this all the time," Sim said. "We've gifted you with the Windows brand. Don't screw this up."