Microsoft Online Services is the company's 15-month-old effort to offer businesses e-mail, collaboration tools and customer relationship management as a hosted service. Microsoft won its biggest customer yet, GlaxoSmithKline with more than 100,000 users, earlier this month. Chris Capossela, senior vice president of Microsoft's broad "Information Worker" business, said the company has been surprised by the number of large customers such as GSK and Coca Cola that have signed up for the hosted service, which has seen 2 million "seats" or users added in the last six months. Microsoft expected to have more midsize companies of 300 to 400 employees sign up for the online service -- and it has had those, too.

But the larger customers bring a couple of interesting surprises. First, they have tended to be former Lotus Notes customers, Capossela said. Two-thirds of current customers and 80 percent of those in the sales pipeline use the competing e-mail product from IBM, he said. "Obviously that's a great thing, taking market share from them," he said. (And, an interesting bit of background, Microsoft Chief Software Architect Ray Ozzie, who turned the company toward software plus services with a landmark memo in late 2005, created and led development of Lotus Notes back in the day.)

Second, these large companies have tended to want dedicated "single-tenant" servers within Microsoft's data centers. They pay Microsoft more for that, but the company also has higher costs to operate servers on the single-tenant model, Capossela said.

While he's pleased with the new customers, Capossela does not see a major change taking place within Microsoft's big Exchange business right away. "Exchange is a monstrous business, so it's not like the business is shifting to online overnight." He does expect half of Exchange mail boxes to go online in the next five years or so.

"That will absolutely show up on the balance sheet," Capossela said. "Customers pay us more money when they subscribe to Exchange Online than when they buy Exchange Server. They spend less money overall, but they're spending more of their money with us."

There are ongoing operating costs associated with that, but Microsoft "likes" the profitability of both business models, he said. The company "loves" that the subscription model brings a more predictable revenue stream and frees the company from having to convince customers to pay to upgrade to the next version of its software -- because they'll get it automatically, as long as they keep paying the subscription.

While a relatively small group of third-party Microsoft partners host Exchange and SharePoint -- two of the products that are part of Microsoft Online Services -- there is a larger group that hosts the company's Dynamics CRM (customer relationship management) software, selling it as a service to customers. Kirill Tatarinov, who runs Microsoft's business applications arm, explained recently that those partners resell CRM Online hosted in Microsoft's data centers, in addition to offering it as a hosted service on their own. The key is differentiation.

"They differentiate by supporting specific industries," Tatarinov said. "They differentiate by adding extra capabilities ... by providing more models and more value and they obviously ask for a higher price for the offering that they have. And we're totally fine with it. That is 100 percent aligned with the power of choice strategy."

Tatarinov said the partners are fine with it, too.

Another major piece of Microsoft's online services puzzle is Windows Azure, the company's platform for hosting third-party online applications and services. This is a competitor to Amazon Web Services, among others. CEO Steve Ballmer said last month that Azure should make significant progress and be able to go to market by the end of the year.

Steven Martin, senior director of Developer Platform Product Management for Microsoft, said much of the discussion has centered on how application hosting can benefit start up companies. A young Web company can get its application up and running in a hosted data center fast and without the risk of buying and maintaining its own servers. But Martin also sees an opportunity with larger, established companies that currently host their own critical business applications in-house -- again because of the choice and flexibility the platform offers, he said.

Martin said the recession has increased attention toward online services such as Exchange Online as companies look to cut IT costs.

"On [the Azure] side we're certainly more, I'd say, exploratory, where people are considering the emerging model. A lot of enterprises are devoting a couple of developers to check it out, doing some testing, prototyping. ... And they're building their three-, five-, 10-year road map for how they're going to think about taking advantage of it," he said.

That's what Microsoft thinks CIOs should be doing now. "Think about where you could take advantage of hosted solutions, cloud-based solutions and how you might evolve your current application portfolio against that. .. How does that change the economics?" he said. "So, a lot of investigation right now, which in the next few years will lead to high levels of consumption."