Microsoft's Internet Search and Ad Plans (MSFT)

Citigroup analyst Mark Mahaney's four takeaways from a conference call with Matt Rosoff from Directions on Microsoft, an independent industry research company. The focus of the discussion was Microsoft's Internet advertising and seach engine development plans:

1. Microsoft has substantially increased its focus on Internet advertising and search engine advertising in particular : According to Matt, MSN’s R&D budget for FY07 will reach $1.1B, up from $700MM in FY06. Further, there has been a 35% increase in staffing at MSN since September. And finally, MSN will spend $700MM in capex in FY07, up from $300MM in FY06. (Separately, Matt stated his belief that Microsoft’s Internet management team is now “A” league.)

These are clearly significant and ramping sums. For context, we provide below a comparison of these outlays with our estimates for Google and Yahoo!’s 2006 R&D and capex spend. The takeaway here is that MSN’s expected R&D spend is 25%-45% greater than Google and Yahoo!’s expected spend levels (although the time periods only partially match). On the other hand, MSN’s expected capex spend is only 40% that of Google’s expected spend level, though 25% greater than Yahoo!’s expected spend level.

2. Why is Microsoft substantially increasing its focus? According to Matt, two reasons. First, Microsoft sees a very large and currently missed opportunity in online advertising. Microsoft believes online advertising could become a $30B worldwide market in three years. And if Microsoft is able to gain 30% market share, that’s a $10B revenue opportunity. Second, and less important according to Matt, Microsoft believes that its PC software franchise may be facing a distant, potential threat from networked applications, although Google would unlikely be the main competition here. So Microsoft is looking to increase its presence on the Internet.

For context, we provide below Citigroup’s global Internet Advertising forecast. The simple point here is that we too see a $30B global Internet advertising market, although we see it in two years (2007) rather than in three (2008).

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3. Windows Live as MSN Version Next: Matt described Microsoft’s new Internet strategy as one that will be based on Windows Live, which he described as a rebranding of MSN’s existing services – Hotmail, MSN email, etc. He said it would also include a new online shopping comparison site as well as an online classified ad site similar to Craigslist. One of the core elements of Windows Live will be the new AdCenter platform, the search engine campaign tool for advertisers and marketers. Microsoft will be looking for paid search opportunities all across its Windows Live properties.

From the Internet perspective, one open question we have is how well Microsoft will be able to brand and market its new Windows Live and Live.com properties. The surprise to us is that Microsoft would look to downplay its well-known and well-established MSN brand. Seems like Microsoft would be running a two-brand Internet campaign. Odd.

4. What steps can Microsoft take to gain share in the search space? Matt referred to potential efforts by Microsoft to lower overall keyword pricing and to incentivize consumers to switch some of their searches from Google and Yahoo! to Microsoft. But according to Matt, Microsoft perceives its “hidden advantage” to be its ability to integrate search into its core Windows applications. As one example, he cited the integration of online maps and driving directions into Outlook.

From the Internet perspective, we clearly agree with the “hidden advantage” point. We believe this has been one of the rationales behind Google’s OEM distribution deals with Dell and others. But we’re skeptical on the pricing and incentivization points. Google and Yahoo! don’t set search keyword pricing. Advertisers bidding against each other for placement do this. So Microsoft’s pricing options are likely limited. And the problem with consumer incentives – “an X-Box for every 10,000 searches!” – is that they will likely reduce the quality of the leads advertisers and merchants are paying for.