July 2, 2001 12:07 PM PT
ROCHESTER, N.Y.--Shortly after Thanksgiving last year, Philip Gerskovich, who was deep into the design of a new digital camera for Eastman Kodak, discovered his company was headed for a collision with Microsoft.

His team was developing new software to manipulate digital photos and needed to make sure it was compatible with Microsoft's latest version of Windows, the basic software that runs most new computers. An early version of Microsoft's newest software, code-named Whistler, had just arrived at Kodak's software labs. When Mr. Gerskovich and his team loaded it onto their computers, they were shocked by what they saw.

When Kodak cameras were plugged into a PC loaded with Kodak software, it was Microsoft's own photo software that popped up--not Kodak's. Camera customers would have to go through a cumbersome process to get Kodak's software to pop up every time, and most would probably just use Microsoft's.

More troubling, the Kodak team found that the new program steered orders for picture prints to companies that would have to pay to be listed in Windows, and that these companies also would be asked to pay Microsoft a fee on every photo sent through Windows.

The Kodak team felt double-crossed. They had worked with Microsoft and the camera industry for a year on a new photo-transfer standard that allowed Windows to recognize when a camera was plugged in. Now, Kodak felt, the standard was being used against Kodak and other digital-camera makers, because it favored Microsoft's competing camera software, embedded in the planned new version of Windows.

We were being frozen out," says Mr. Gerskovich, a 44-year-old Kodak vice president. "Consumers were effectively being denied a choice of which photo software they could use. More important, they should be able to send photos to any Internet printing service they choose--without paying a tax to Microsoft."

Kodak's story offers a snapshot of a now-familiar tale in the software business. Despite the government's antitrust case against Microsoft, which was partly upheld and partly reversed by a U.S. Court of Appeals last week, the software giant continues to use its monopoly operating-system software as a lever to pry its way into new businesses. And companies such as Kodak are responding by crying foul, hiring antitrust lawyers and lobbyists.

Microsoft rejects any suggestion that it misbehaved. "Kodak is an important partner, and we want their products to work well with Windows," says Vivek Varma, Microsoft's chief spokesman. But Kodak "didn't respond to our numerous attempts to work with them to correct the problem. These are complicated technical issues, and Kodak should have tried harder to work them out with us before running to their lawyers and Washington lobbyists."

Mr. Varma adds: "Any suggestion that we had hidden motives in the design of Windows XP is untrue."

For Kodak, the battle for the PC-driven photo business is crucial. Kodak is trying to transform itself from a fading business icon into a nimble technology company. It is the leading seller of traditional film, which generates the vast majority of its profits. But with the growth of filmless digital cameras, that franchise promises to shrink and might someday even disappear.

Kodak so far has been unable to create digital products or services that could replace film in the all-important consumer market. Mr. Gerskovich's camera and its allied software are seen as the best hope. The company's plan is to use the Internet to drive its digital-camera customers directly to Kodak picture labs to buy their prints. Any Microsoft obstacle would be a critical strategic blow to Kodak.

The confrontation hints of antitrust battles to come, as other companies grasp the reach of Microsoft's plans for the coming new version of its operating system, Windows XP, and its ambitions on the Internet. From photography to phone service, music to banking, companies across the economy have been waking to find Microsoft riding its operating system into their markets--even as it was awaiting the outcome of the landmark antitrust case. Microsoft has targeted RealNetworks, the pioneer of music and video on the Internet, and AOL Time Warner, in the booming market for instant messaging, with much the same aggressiveness it once used in going after Netscape, in the browser battle that led to the antitrust case.

Kodak launched Mr. Gerskovich's new camera, EasyShare, at a splashy event this spring at the fashionable W Hotel in New York's Union Square. Chief Executive Daniel Carp opened the affair by observing that digital cameras hadn't caught fire with the mass market because they were too complicated. "The key to this is to make it simpler," he said. "No one wants to be called average, but the fact is most consumers are average." Then a parade of actors, from a grandmother to a 10-year-old girl, ran the product through its paces to prove the theme: "You press the button, we do the rest."

The words were those of George Eastman when he brought out the first mass-market camera, the Brownie, in 1900. Now, Kodak hopes EasyShare will be the digital Brownie. Kodak pioneered digital picture-taking technology in 1976, and digital products are its fastest-growing market, producing $3 billion of its $13.9 billion in revenue last year. But the company still relies on film, paper and photo processing for most of its revenue.

Indeed, Kodak dominates photographic film in the U.S. and has been accused of being a monopolist itself. It faced private antitrust suits in the 1970s and 1980s, which were cited in last week's appellate-court ruling in the Microsoft case. It was Microsoft's chief trial counsel, John Warden, who back in 1979 rescued Kodak from an $87 million judgment, after a rival argued that Kodak had broken antitrust law by making Instamatics that didn't take standard film.

Price war
A price war in 1997 with archrival Fuji Photo Film Co. of Japan led Kodak to cut its payroll, change its strategy and invest in new technologies. The results have included numerous digital-camera products and now, EasyShare.

EasyShare was developed at Kodak's sprawling research complex outside Rochester. There, Mr. Gerskovich and his team work in a windowless lab room ringed with computer screens, developing their own photo software to let a PC user crop, rotate, store or send digital photos.

They also study the latest "builds" of Windows XP, which is due in stores this October. In existing versions of Windows, the user can easily make Kodak's product the "default" option for photo software after installing it. But when Mr. Gerskovich saw early versions of Windows XP last fall, he realized Microsoft's photo software was treated preferentially.

Over and over, Kodak's team tested the installation process on Windows XP. They say it took nine mouse clicks--through a series of Windows instructions and folders--to get Kodak's software installed as the default after a camera was plugged in. "Every one of my customers is going to have to call our tech-support line" to get the software to work, Mr. Gerskovich said. "Many will give up," and just use Microsoft's photo software.

Moreover, Kodak would be giving up online photo-processing revenue, because users would be guided to Microsoft's business partners. These companies would be listed in a pop-up box and would pay Microsoft a portion of their revenue for that privilege. "It's obvious they wanted to make it as hard as possible. A lot of thought went into this," Mr. Gerskovich contends.

Kodak, with a photo-printing business estimated by analysts at $2 billion a year, hopes to be among those listed in Microsoft's photo software. But ideally, Kodak would prefer to reach customers directly, through its own software installed in the PC by Kodak camera buyers. This would allow it to compete without paying what it calls a "tax" to Microsoft.

Most galling for Kodak engineers, it seemed that Microsoft had effectively hijacked the camera industry's new picture-transport standard, its common technical means of moving images from camera to PC. "Together, we built a highway that everyone could travel, and Microsoft put up a tollbooth," Mr. Gerskovich says.

Microsoft responds that users will be free to install links to other photo printers. "Companies can be added to that list at any time," Mr. Varma says. "We designed it to be an open feature."

To the people at Kodak, Microsoft's photo software didn't measure up. While testing a later version of it, Mr. Gerskovich and his team uploaded a dozen ordinary photos taken around town. Then Mr. Gerskovich tried to rotate one of them, an image of a Kodak engineer's mother at a birthday party. A Windows warning box popped up, saying the photo would be rotated--but doing so might eliminate the original image. "Do you want to proceed?" it asked.

The box also warned, somewhat mysteriously, that "because the picture is not even a multiple of 16 pixels in both dimensions, the picture quality may appear degraded after rotation." The user was offered "yes" and "no" boxes to click. As team members read the warning box, laughter filled the darkened Kodak lab.

"We'd never put something like this in our software," says Mr. Gerskovich, who has studied what he calls the "chain of pain" that consumers face when using current photo software, including Kodak's. In designing EasyShare, he says, "we did months of consumer testing and human-factors research. Pictures are our business. We know, for example, that consumers expect something like a 'digital negative,' " a copy of the image that isn't altered when editing software is used.

Microsoft responds that its photo software, like Windows XP itself, is still being fine-tuned. In any case, the company says, it isn't intended to replace fully featured programs such as those made by Kodak, Hewlett-Packard or Adobe Systems.

The dispute came to a head at a meeting Microsoft held near its headquarters in Redmond, Wash., on March 22. The hotel gathering in Seattle was billed as a pep rally for Windows XP, designed to build support for the product and boost morale at companies with a stake in how fast it was adopted. Hundreds of managers and engineers from computer, printer and software companies attended.

During a break, Mr. Gerskovich approached Microsoft President Steve Ballmer, who was standing in a knot of people near a snack table, and asked his question point-blank: Will Kodak's photo software be able to launch easily, as it does in current versions of Windows when a camera is attached? Mr. Gerskovich won't say what Mr. Ballmer answered, but Kodak has told its lawyers and others briefed on the incident that the response was unequivocal: "No way."

Mr. Varma, the Microsoft spokesman, rejects Kodak's version of this exchange and says that Mr. Ballmer asked another executive to work with Kodak to resolve the dispute. The Microsoft spokesman also says that Kodak was seeking special treatment and had been unable to make its software work "despite our repeated attempts to get them to engage and deal with the technical problems they were having."

Calling in the lawyers
Mr. Gerskovich sounded an alarm inside Kodak. Some managers argued against taking on Microsoft, citing the retaliation documented during last year's trial. Others said Kodak had to take a stand. Kodak hired antitrust lawyers in Washington and began to map its options. At one point, it even considered asking a judge to block release of Windows XP on the ground that it was meant to obstruct Kodak's software.

In April and May, Kodak lobbyists made the rounds in Washington alleging that Microsoft was again trying to abuse its Windows monopoly. The message was heard on Capitol Hill. It was one thing for Microsoft to attack another software firm, says a Senate staffer, but muscling a household name such as Kodak "could change the debate." Word quickly got back to Microsoft, as well, and by last month its public-relations firms were working to counter Kodak's claims.

At the start of June, Kodak's Carp called New York Attorney General Elliot Spitzer to brief him on what Kodak considered an antitrust issue. Spitzer won't comment, but others close to the broader federal antitrust case suggest Kodak's story could play a role in new proceedings on a Microsoft remedy, which were ordered by the appeals court.

Microsoft continued to send out versions of Windows XP. Three weeks ago, Kodak got the latest, numbered "build 2481." Kodak engineers say this version has a new, simpler way to launch photo software after a camera is plugged in. Instead of a nine-click process of setting non-Microsoft photo software as the default, it lists competitors' programs alphabetically in a pop-up box, along with Microsoft's.

It isn't all they want, Kodak engineers say, but it's a big improvement. Instead of a roadblock, "it's just a speed bump," Mr. Gerskovich says.

A 'miscommunication'
But Microsoft hasn't backed down on plans to charge a per-photo fee for images that are sent through Windows to Microsoft's partners, others in the industry say. One of those partners is likely to be Kodak rival Fuji, which already works with Microsoft in an alliance with its MSN Internet service. Microsoft says terms of its contracts with photo-finishers aren't final; it won't comment on how these companies will be charged.

Microsoft, trying to ease tensions between the companies, says much of the flap with Kodak is a result of "miscommunication." Any change in the latest version of Windows XP, Microsoft adds, had nothing to do with Kodak's complaints. "I wish we could say we did this in response to Kodak, but the fact is we always had a design goal of making the experience easy for consumers and fair to all of our camera partners," Microsoft's Mr. Varma says.

Other digital-camera makers, such as market leader Sony, are strong supporters of Windows XP and haven't raised the same technical complaints Kodak claimed. But among these companies, only Kodak and Microsoft's partner Fuji are in the online photo-finishing business.

In a letter to Microsoft after tensions began to ease last month, Mr. Gerskovich sought assurances that the pop-up box allowing users to choose their photo software will be in the final version Windows XP. "Our business plans depend on this, and its absence would wreak havoc on our digital camera strategy," he wrote. Microsoft says the box will be there, and that Kodak's software will launch easily, just as it has in past versions of Windows.