Internet Outsider

Google/Microsoft: Careful What You Whine For

One of many smart comments/links to the last post re MSN's deterioration concerned the default search setting for the forthcoming IE 7.0.  As the NYT details, Microsoft is embedding a search window in the browser header of 7.0 with MSN as the default search engine (or "Live" or whatever the Microsoft engine is or will be).  Google, meanwhile, is complaining that this is an abuse of power, that Microsoft should be forced to make every new PC user walk through set-up screens that choose the default.  Commentators are using the tiff as a way to suggest that Google is in trouble, Microsoft is about to pull a Microsoft (come from behind and win the web game), etc.

Thoughts:

• First, hats off to Google for keeping a straight face while complaining about this.  Microsoft's monopolistic bullying, apparently, theatens to boost MSNs 11% share of search while chipping away at Google's 50%-share--so it's clearly worth tax-payer dollars to get the regulators involved.  Also, the Google toolbar that Google smuggled onto my PC in a "Java update" package last week has not only embedded a Google search window in my (Microsoft) browser but made it look like the browser was made by Google (the word Microsoft is nowhere to be seen). 
• Second, hats off to Google for realizing that, although the idea that Microsoft's plan is somehow monopolistic bullying is ridiculous, the idea that regulators, especially the EU, might not see it that way is not.  Regulators usually fight the last war, and if Google succeeds in getting them up in arms about this non-event in a new world in which Microsoft is the farthest thing from a monopolist, more power to Google.
• Third, according to the NYT, Microsoft is not hard-coding MSN into every browser but, instead, giving PC makers the ability to charge search providers a fee to be the default search engine.  If Google wants that slot, in other words, it doesn't need to complain about it--it can just use a tiny fraction of its gigantic cash pile to pony up. 
• Fourth, users can change the pre-set default easily, just as they can with the IE home page (which also comes set to MSN, and which hasn't exactly stifled Google's growth).  That many don't hasn't helped Microsoft do any better in the web business than a distant and nearly irrelevant third.
• Fifth, I don't have the numbers to back it up, but Google's end-of-the-world-as-we-know-it estimate in the NYT that 30%-50% of users will use the embedded search window strikes me as absurdly high. 
• Sixth, even if Microsoft does what it plans to do, I don't see this as a major game-changer, at least not re Google.  For most people, Google equals search, and no window is going to change that (unless it's Google's).  I get the sense that many of Yahoo!'s searches, however, are driven by convenience--MyYahoo users using the closest box--and if an embedded window in IE is even more convenient, then that could be bad news for Yahoo.

Bottom line, Google's public complaining about such a small issue seems to me evidence that its sense of itself (quirky, aggressive start-up) still hasn't quite caught up with its reality (global behemoth).  If so, of course, this is a DNA trait it very much shares with the even more dominant global behemoth to the north.

MSN: Another Quarter Closer To Irrelevant

As shown by yesterday's numbers, MSN’s financial performance continues to deteriorate.  With each passing quarter, in my opinion, the chance that the division will ever mount a serious challenge to Google and Yahoo in search (or any web business) gets slimmer and slimmer.

• MSN advertising revenue rose only 7% y/y, a deceleration from December’s mediocre 12% and September’s 20%.  This compares to Yahoo’s 34% and Google’s 79%.
• Search revenue actually declined y/y.  Microsoft blames this on the transition to adCenter, but shrinking revenue in a market growing this fast is a terrible sign.  All else being equal, shifting to adCenter modestly increases revenue-per-click because MSN goes from booking net revenue to gross revenue.  This illustrates just how much revenue is being lost due to lower keyword prices on adCenter than Yahoo.
• Operating income also declined, from positive $102 million to negative $26 million.  The division is now detracting from the performance of Microsoft as a whole.
• The plunge into the red resulted from declining revenue and a headcount increase of a whopping 35%.  Whatever the new folks are doing, they aren’t selling ads.

MSN’s heavy investment in headcount and R&D, combined with a renewed willingness to run the division at a loss, shows how seriously Microsoft is taking MSN and the Google threat.  Despite this, however, the division’s performance shows no signs of a turnaround (on the contrary, it just gets worse).   Analysts and commentators conditioned by years of Microsoft’s come-from-behind victories in software continue to act as though MSN’s ascendancy is only a matter of time.  The numbers (and general business history) suggest otherwise.

Microsoft has been at the web business for 11 years now--and it is still running a distant third.  How long Microsoft will continue to believe that gaining real traction online is just a matter of hiring the right people, developing the right algorithms, or spending the right amount of money remains a mystery.  Unless the MSN division soon shows signs of first stabilizing and then regaining share, however, even the Microsoft faithful may eventually have to throw in the towel. 

The hirings of Steve Berkowitz, Ray Ozzie, etc. are positive, but, for MSN, they are probably too little too late.  I continue to believe that the best solution to a tough problem is a spin-off.  It worked for Expedia, Slate, and other Microsoft web businesses, and it still has a chance of working for MSN.  Also, why any one company wants to have $50 billion in revenue and compete with IBM and Oracle on one end and Google, Time Warner, and Sony on the other is beyond me. With each successive re-org, however, it becomes clearer that Microsoft is deadset on doing just that.

Microsoft Doubles Down, Swallows MSN

For a few years, Microsoft has been standing at a fork in the road: Spin off its web and consumer businesses or integrate them deeply into the fabric of the company. The latest re-org suggests that, despite getting its head handed to it in the online business for the last 11 years, Microsoft has chosen the deep integration path once and for all.  Given what is at stake, this amounts to doubling down. 

Henceforth, MSN, et al, will be part of the "Online Businesses Group" which, itself, will be one of eight divisions within a massive Platforms and Services Group.  Yusuf Mehdi also seems to have finally been put out to pasture with the ceremonial title of chief advertising strategist, perhaps to make way for new blood.

As I've argued, I think this is the wrong route for Microsoft, at least if the company is serious about challenging Google in the search and advertising-driven web services business.  The more MSN is subsumed within the Microsoft whale, in my opinion, the more the web efforts will exist just to protect a dying Windows monopoly.  Integrating the Internet with Windows has done little to help Microsoft dominate the online business: Despite 11 years of effort, tens of billions in cash, a browser monopoly, a desktop monopoly, and thousands upon thousands of brilliant engineers, the best the company has ever been able to do is run a distant third.  I don't see anything in the latest re-org that begin to change this; instead, I think it will exacerbate it.

I also remain skeptical that a company that dominates the world of corporate IT (enterprise scale corporate software and productivity tools sold to Fortune 500 CTOs) can also dominate a media business, which is what search and portals services are and will remain.  The differences between the two businesses (and customer bases) are vast, and the conflicts will forever force compromise.

This isn't the end of Microsoft: the company's position in enterprise IT (and on some desktops) should be secure for decades.  It could, however, be the beginning of the end for MSN.

Google-Writely To Kill Microsoft? No.

Yes, I am being forced to evolve my belief that Google would never be so dumb as to compete with Microsoft's core business.  I continue to believe--and I think the purchase of Upstartle bears this out--that Google is smart enough not try to take down Redmond by persuading corporations to switch to Open Office.  But it does seem undeniable that Google views its competition as Microsoft (and, therefore, the tech industry) instead of Yahoo! and the media industry.

This said, some of the jubilant "Redmond is toast!" rhetoric that followed the Writely buy ignores a few points.  To wit:

Microsoft makes the vast majority of Office revenue from corporations, governments, and other organizations, not individuals.  Although there is undoubtedly a market for personal office productivity tools--a portion of which might be interested in a free, web-based alternative like Writely--this portion is comparatively tiny.  This is important because most corporations are not going to allow (much less encourage) employees to use web-based tools to create job-related documents unless and until they are certain that all issues regarding security, reliability, ease-of-use, storage, and compatibility have been resolved.  One reason Microsoft has continued to make hay with Office even with the existence of Open Office and other alternatives is that corporations have more important considerations than "free."

Next, of the small percentage of the office-productivity market that is looking for cheaper, personal solutions, the fraction that really care about FREE already has plenty to choose from.  They can download Open Office, for example, or boot up WordPerfect.  The reason these products have not made a dent in the Word monopoly is not that they suck (although many do).  It's that 1) no one else uses them, creating compatibility headaches, and 2) that Microsoft Word just isn't that expensive relative to the value it creates. 

Third, let's assume that Writely is in every way the equal of Word and that no Writely user will ever buy another copy of Word.  How is Google going to make money from this?  AdWords?  AdSense?  Probably not.  No self-respecting professional is going to tolerate ads inside documents, and if Google tries to stick them somewhere in the browser, click rates will likely be low (when you're writing, you don't waste time clicking--one reason email ads don't make much).  Display advertising?  Again, probably not.  The trade off between paying $100 for an ad-free word-processing environment and having your screen look like a NASCAR hood is one few corporate users will make.

So then subscriptions?  Maybe.  But if users are paying money anyway, why not pay it to Microsoft--especially if/when Office Live delivers its own web based solutions.  Unlike Google, Microsoft really knows what it's doing in this arena.  If both are going to charge me, I'm not going to be in a hurry to switch.

No revenue necessary?  Google Word will just be a hook to bring in users and keep them on Google all day?  Well, maybe, but it's hard to see the value in this, especially when there is such a gigantic amount of money to be made in other areas of Google's business.  Google is already spending way too much on CAPEX, and some day, when the stock's in the tank, they will presumably cut back on revenue-less storage hogs.

One thing that's for certain is where the revenue is NOT going to come from, and that's where Microsoft's comes from: Out of Fortune 500 technology budgets.  Unless Google radically--and I mean radically--shifts its focus, it is not going to be persuading Fortune 500 CTOs to rip out Microsoft anytime soon.  The enterprise software business--the business Microsoft, IBM, Oracle, etc. compete in--is completely different than the business Google competes in (media).  As Microsoft itself has learned--the hard way--the media and enterprise software businesses require different salespeople, different client contacts, different value propositions, different budgets, different everything. 

Another thing is for certain: Yahoo!, AOL, Time Warner, and the rest of the media world would like nothing more than for Google to go charging off on an Ahab-like quest to harpoon the Redmond whale--because the vast resources this would require would almost certainly weaken Google's chokehold on the search business.  Even Microsoft is probably salivating at the thought that the Google guys will become so obsessed that they take their eyes off their crown jewels.

So, yes, it has become undeniable that Google has its heart set on giving users a way to write documents, maintain calendars, and do email.  What is less clear is why.

MSN Falls Farther Behind

The press hype about a coming "war" between Google and MSN has mercifully abated in recent weeks, perhaps because it is becoming clearer that, far from being a credible Google challenger, MSN isn't even in the same league.

Last week, Microsoft reported MSN's December-quarter results, which were, in a word, weak.  Advertising revenue rose a dismal 12% year-over-year, continuing the deceleration trend of the last few quarters (by comparison, Yahoo!'s growth was 39% and a poor showing for Google will be in the 100% range).  Operating income dropped 55% to $58 million, as salesforce and developer headcount ramped.  Any indication that this investment will ever pay off will have to wait for another quarter.

The key to MSN's recovery (and relevance) is search, and search revenue was awful.  The company's display advertising revenue grew 20%, only half of Yahoo!'s growth rate but far better than MSN search, which apparently posted growth in the low single digits due to a 20% year-over-year drop in revenue per search.  The company attributed this trend to the adCenter ramp-up (Overture's revenue per keyword is presumably higher than adCenter's) and weak performance from third-party partner sites.

The one important bright spot--and, considering the rest of the division's performance, it's a head-scratcher--is that search query growth was in the "low to mid double digits" (presumable translation: 20%-45%).  This means that all is not lost.  If the company can get its act together and stabilize revenue-per-search, query growth alone should produce nice revenue growth.  Based on recent trends, however, this seems anything but a lay-up.

As argued here, MSN is, at best, competing with AOL for distant third place in the web wars.  The December quarter results--combined with AOL's recent partnership with Google and broadband distribution deals--suggest that MSN is even losing ground in this race.  Google, meanwhile, is so far ahead that it's not even visible over the horizon.

And Did We Mention Googlesoft?

Okay, fine.  Google's reported second announcement at CES tomorrow, the "Google Pack" of brand-name non-Microsoft software programs that are a pain to download one at a time, does put the company in more direct competition with Microsoft. 

Fortunately (for Google's sake), the Pack is not rumored to include a free office suite: The programs in the pack are all plug-ins, not platforms or enterprise productivity tools, and some of the apps included (RealPlayer, Trillian) are also-rans that add about as much value to the user as free copies of Lotus and WordPerfect. 

The day Google starts hawking free office suites, in my opinion, will be the day the company has strayed too far from its core business to credibly protect its crown jewels (the search engine) and also gain share in lucrative opportunities much closer to home (portal services, content, commerce, communications).  It will also be the day that Microsoft will no longer have the luxury of struggling over future pots of gold, but, instead, will be forced to defend its own crown jewels.  And in this arena, despite its weak showing on Google's home turf, I have to believe Redmond will put up a bit of a fight.

Exploring Gates' Pay-Users-To Search Idea

Bill Gates's ruminations about compensating users for searches hit the mainstream this morning in the WSJ.  The concept also prompted much thoughtful commentary over the weekend, both here and elsewhere.

Several readers pointed out, for example, that the concept is not new: Amazon's A9 gives searchers a small rebate on Amazon once they meet a certain threshold (number of searches).  This method controls the most obvious problem with the idea, which is the potential for massive click-fraud.  The A9 discount is small, so it is hard to know how effective a lure the offer would be if it amounted to, say, 25%-50% of the value of the clicks a given searcher generated, but it is worth noting that it has not helped A9 gain much traction in the search wars.

Given the threat of click fraud, a large MSN program would probably have to take the form of something like frequent flier miles or reward points instead of cash, and it would also probably have to be tied directly to purchases (users would only get their points if/when they actually bought something from a search advertiser).  The reward would also have to be meaningful in size, especially at the beginning, or most users probably wouldn't even bother to establish an account.

If the program were structured this way, however, and if it allowed the average searcher to generate a meaningful amount of value over the course of a year, it would likely help MSN both gain share and retain users.  This said, unless MSN shares a major percentage of search revenue--say, half--the program would not likely gut Google's current cash flow or force it to respond in kind.  Right now, most web users search on Google because they equate it with search and because they are creatures of habit.  And it costs more to break habits than a few pennies a month.

Get Paid to Search: Now MSN's Talking

Finally, an idea from Microsoft (or at least from Mr. Gates) that might actually cause some tremors in the paid search world.  Instead of keeping all that super-high-margin search revenue for itself--the way Google does--Microsoft is apparently thinking of sharing some of it with the folks who create most of the value: the searchers.  Or so Mr. Gates reportedly described in India (via Infoworld and Mr. Battelle).

How, exactly, the company would do this remains a question, but the idea is far from absurd.  When your mere click on a link generates a couple of dollars of pure profit, it's easy to see how you might come to believe that getting paid something for your decision/attention is fair.  And at current prices, Google could split per-click revenue 50/50 with searchers and still have plenty of profit to spare.  (Of course, the stock would drop 80%, but that's a different issue).

The important point here is that installing some sort of revenue sharing system is not the same as competing by offering the competitor's product at 50% off (a strategy that might earn some market-share gains but will eventually lead to cash-bleed and mutual destruction).  It's also not the same as building a whole business model around paying users to look at ads, as some of the 1999-era dotcoms tried to do.  Without a true network effect, there is no free-market justification for incremental profit margins in the 90%-plus percent range, as Google's are now.  And if MSN, Yahoo! et al can't compete on functionality and user experience, then perhaps they can lure Google searchers away with other incentives.  Especially because even the most ardent Google fan may someday begin to resent the fantastic amount of money that they make for Google each time they click--an amount that, arguably, vastly exceeds the value of search results Google is providing. 

What Microsoft Should Do

Yes, it's fun to piss and moan, but once in a while, you have to put yourself in the CEO's shoes.  So here's a response to reader Bruce Hamm's question of two days ago: What SHOULD Microsoft do?

(First, I should clarify my position regarding Microsoft:  My position is not that Microsoft's web business sucks.  It doesn't.  Microsoft is either the third or fourth strongest web company on the planet.  My position is that the common idea that Microsoft is going to do what it has done in many software businesses--come from behind, bury Google and Yahoo!, and rule the web--is ludicrous.  Microsoft has been trying to come from behind on the web for a decade, and it is almost as far behind now as when it started.  A few more years--or Microsoft Live, or AdCenter--is not going to change this.)

So what should Microsoft do?

1) Merge MSN with AOL in the complex transaction described below.  Do NOT enter into a "partnership" with Time Warner.  Time Warner has had enough trouble managing AOL by itself; don't make things worse with a joint venture (a.k.a., a "joint agreement to take no responsibility" and/or "joint headache").  As part of the deal, give the combined company a right of first refusal on Time Warner content and Microsoft software and insist on a good distribution deal with Time Warner Cable.  Pay for the purchase with stock in the new company, called, for the sake of this post, AOL-MSN (see No. 3 below), with Microsoft and Time Warner each keeping a major chunk of the equity.

2) Eliminate duplication: development teams, VOIP efforts, content platforms, network operation centers, bandwidth deals, sales forces, call centers, etc.  Make the two IM systems interoperable.  Make AOL mail work with Outlook.  Put both companies on the same search and advertising platform. Unify the mission.  Take the best of both management teams and hire new blood.  Etc. 

3) Spin the combined entity off as a separately traded public company, with Microsoft and Time Warner together owning about 70%-80% (but neither having a controlling interest) and the public and other strategic partners owning the rest.  Make sure the company has at least $5 billion in cash. 

4) Cut broadband distribution deals with cable companies, telecom companies, and wireless companies.  Start with Comcast, which wants access to the AOL subscriber base so badly that it's talking to Time Warner on its own.  Focus efforts on trying to migrate dial-up subscribers that want to quit AOL to broadband partners, thus retaining some revenue.  (In each market, at least two broadband distributors compete with each other, and they would both love to attract AOL dial-up subs.)  Consider buying Earthlink, United Online, etc., to gain more leverage in these partnerships.

5) Combine the portal infrastructures of AOL and MSN and gradually migrate toward a single brand in each geography in which one is weak.  Integrate the portal with Windows (Microsoft will still be a strategic parner).  Leverage Time Warner content (Time Warner will still be a strategic partner). Consider partnering with News Corp., which should have a stake in a major portal.  Partner with News Corp's MySpace, and provide technology and content to MySpace's users.

Why merge?  Because MSN and AOL are currently fighting it out for No. 3 in the web wars, and neither has a realistic shot of gaining market share by itself (let alone becoming No. 1).  Merging will create a stronger No. 3, with about $2 billion of annual cash flow, the world's leading online communications services, strong positions in the U.S. and internationally, strategic partnerships with the world's leading media and software companies, etc.  And also merge because most markets only support three major generalists, not four, so the future for either company alone looks bleak.

Why spin the combined company off?  Because the immense personalities and talents needed to pull off a merger like this probably won't want to work for massive conglomerates for whom the Internet is a sideline business (Microsoft or Time Warner), especially when they get paid in the conglomerate's stock options.  Because the conflicts and infighting at Time Warner and Microsoft are stifling the growth of the web businesses.  Because being a stand-along company will increase focus and pressure on management.  Because Microsoft and Time Warner shareholders will benefit as much, if not more, from owning equity in a strong No. 3 web company (AOL-MSN) than from owning a controlling interest--and consolidated cash flows--of same.  Because the combined company will be able to develop its own personality and identity, which it needs to be able to compete with ubiquitous global Internet brands like Google and Yahoo!

(For more, please see a recent Cherry Hill Research publication, The Web War is Over...and Microsoft Lost, which I linked to in this post.  It includes a snapshot of what the combined P&L of AOL-MSN would look like, pre- cost cuts).

Microsoft to Kill Google? No.

So the big story these days is that Google and Microsoft are going to war and that either could win.  This is a big story because it's a great story: two undefeated heavyweights preparing to bash each other's brains out.  Alas, it's also fiction. 

Despite ten years of effort, vast technological and financial resources, and a legendary intensity, Microsoft is running a distant third in the web wars (behind Google and Yahoo!)--and it continues to fall farther behind.  Importantly, this is almost the same competitive position Microsoft occupied in 1995, when Yahoo! was run out of a dorm room and Google didn't exist.  Microsoft was trying desperately to win the Internet war then, and it has tried desperately every year since.  And despite all its assets, the best it has been able to do is run a distant third.

From a high level, this is not surprising: the leader of one technology revolution rarely dominates the next.  Microsoft is an enterprise software company, not a consumer web services company, and therefore its success on the web is commendable.  Commendable does not mean dominant, however, and those who argue that Microsoft's new search technology will suddenly overthrow Google are forgetting all that has happened in the last ten years.

In the absence of disastrous mistakes by Google and Yahoo!, Microsoft's best chance to win with MSN is to merge it with AOL and spin it off.  This would be extraordinarily challenging, and it would not guarantee success: the merged company would still run third behind Google and Yahoo!.  A combined MSN-AOL, however, would be far stronger than either company alone.

At Cherry Hill Research (fledgling industry analysis company), we recently published a piece on this.  Feel free to view if interested.  (The Web War is Over and Microsoft Lost, Cherry Hill Research, Sept 2005)