Pondering the future for Microsoft

It is hardly surprising that Wall Street's heart sank at the end of last week, after the world’s largest software company revealed plans to increase its spending drastically in the coming quarters.

Much of the estimated $2bn-$2.5bn Microsoft is piling on to its spending for next year is believed to be earmarked for its battles with Google and Yahoo – an area where it has fallen woefully short until now.

Despite commanding one of the biggest audiences on the internet, its MSN service loses money, a position that will not improve in the company's next fiscal year beginning in July, Chris Liddell, chief financial officer, said last week.

Nearly three years after deciding to devote some of its brightest minds to building a search engine to compete with its rivals, Microsoft is still seeing its share of the search market dwindle.

“Microsoft has poured a tremendous amount of money into MSN and online services. They have a lot to prove,” says Matt Rosoff, an analyst with Directions on Microsoft.

Wall Street is wondering: is Microsoft on the defensive, rushing to shore up a dominant desktop software business that is in danger of being eroded faster than expected? While Mr Liddell insisted that the extra spending reflected big new opportunities, the $32bn wiped from Microsoft's stock market value in a day suggests investors fear otherwise.

It is all very different from when Google said this month that the amount of cash needed to extend the reach of its own internet services was rising fast. According to estimates from Merrill Lynch, Google's costs will reach $1.1bn next year, $200m higher than MSN's and $400m more than Yahoo's. That has done little, though, to dampen the renewed bout of stock market enthusiasm for the leading search company.

The difference is that Google's online advertising engine is roaring. Its profit margins continued to increase in the first quarter of this year, despite its earlier warnings that margins would start to shrink.

Microsoft's shareholders, on the other hand, face a period of shrinking profit margins – something they had not expected as Microsoft gets into the swing of a new product cycle that has revived its flagging growth rate.

Nor do they have any idea how long this state of affairs will persist. Mr Liddell refused to say whether the shift in financial strategy would be a short-term, or whether it represented a more permanent state of affairs, as the rivalry between the handful of companies that dominate the internet intensifies. A clearer picture will not emerge until the company's annual analyst meeting in late July, if then – another reason why its shares took a beating on Friday.

While Microsoft said its higher investment spending would be spread across a number of markets including video games, where it wants to press an early advantage against Sony with its new Xbox 360 console, the internet remains the area of most need for improvement.

“They've let MSN stagnate,” says Matt Rosoff. “Some of the MSN services hadn't been updated for years, and Hotmail hadn't been updated since it was launched.”

To win traffic, he adds, “they have to a large extent been relying on links in other Microsoft products” such as the Internet Explorer browser. A new range of email and other services, rebranded under the name MSN Live, is expected to be launched formally in the coming weeks.

The real opportunity, however, lies beyond simply revamping the current range of services, according to analysts and technology experts. While Mr Liddell said Microsoft was not using its piles of cash to build a “Trojan Horse” to overthrow Google, many suspect that the scale of Microsoft's ambition is not far short. “The natural opportunity for Microsoft is to become the platform company [for the internet]”, says Nathan Myhrvold, Microsoft's chief technical officer until 2000.

Just as Windows has become ubiquitous thanks to its role as the common platform on which other developers write their software, Microsoft's software could eventually play a wider role on the servers, handheld computers and other intelligent devices whose collective power will make up the computing power of the internet. “All they need to do is sell the parts,” says Mr Myhrvold – potentially a vastly bigger market than the PC business that has come before.

Google, on the other hand, has shown little interest in turning itself into a platform company, he adds. Google's technology is reserved for running Google's in-house applications, while Microsoft's history as a platform software company, and the big following it has among developers, potentially leave it with a bigger opportunity.

If so, Microsoft and Google may be heading in different directions. That may make it less vital for Microsoft to catch up with Google's algorithmic search service, according to Rick Sherlund, software analyst at Goldman Sachs, who also argues that Microsoft's real goal is to build an internet-wide platform.

Yet in at least one way, Microsoft and Google remain on a collision course. Keyword advertising – the targeted messages that appear alongside search results – has become the preferred way to “monetize” many of the new services online. Whatever the eventual nature of the services, advertising-supported software may become the dominant business model.

Microsoft's online advertising network, like its algorithmic search engine, is taking longer to build, and turning out more expensive than Wall Street had hoped. Advertising revenues at MSN grew by only 7 per cent in the latest quarter, when Yahoo's advertising was up 35 per cent and Google's jumped by 80 per cent. With its banner advertising business growing faster, MSN's search revenues actually shrank during the quarter.

Part of the reason has been Microsoft's decision to start generating advertising for MSN with its own advertising network, replacing its relationship with Yahoo. By the end of March, some 70 per cent of ads in the US were coming from Microsoft's own system and it had started to ramp up the service overseas as well. MSN's results will continue to lag as it refines this advertising system, Mr Liddell warned.

The potential bonus for Microsoft, if it can eventually stand toe-to-toe with Google and Yahoo, is that its advertising engine will eventually feed not only its own online services, but could become a key part of the online platform that supports many other businesses.

Before that, though, it seems that Microsoft's shareholders will have to get used to the idea of their company spending many billions of dollars more.