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Microsoft's MSN: Searching for growth
The online service faces tough competition in the ad biz and search. Should it fish or cut bait?
October 28, 2005: 3:01 PM EDT
by Amanda Cantrell, CNN/Money staff writer

NEW YORK (CNN/Money) - When looking at Microsoft's profit-generating potential, there is a lot to like.

On the one hand, the world's biggest software maker is getting ready to launch a hotly anticipated gaming console that's expected to go gangbusters. And major new products in its software and operating system businesses are in the pipeline.

On the other hand, there's MSN.

One of the few soft spots in Microsoft's latest quarterly results was its online division, which posted mixed results. MSN budged just one percent from the year-ago quarter, generating $564 million in revenue.

MSN encompasses a subscription-based internet access business, an online content portal and a search engine. It faces stiff competition from AOL, for access and content, as well as Google and Yahoo! for search and advertising dollars. (AOL, like CNN/Money, is owned by Time Warner.)

MSN: Engine for growth?

While it's still a small fraction of the company's overall business, the future of MSN is important because if it becomes a successful competitor to Google and Yahoo, the acknowledged leaders in the search category, MSN could deliver some much-needed growth to Microsoft.

The company's shares have been treading water for more than three years, and analysts and investors are desperate for any kind of growth, especially now that the company's flagship software and operating system businesses have matured and analysts and investors don't see significant growth prospects for either.

Optimists who think MSN could drive growth for the company point to the success it had in its server software unit. Jamie Friedman, an analyst with Fulcrum Global Partners LLC, said that while building the unit was slow going at first, it has grown into a business with good margins, and one that helped drive revenues in the current quarter.

Advertising, which constitutes about 75 percent of MSN's revenue according to Goldman Sachs, grew 20 percent year over year. MSN generates ad revenue from display ads on the MSN.com Web site as well as through ads that come up when people use its search engine, an area in which Google and Yahoo! dominate.

But ad revenue for MSN fell four percent from the previous quarter, and Microsoft chief financial officer Chris Liddell admitted that revenue tied to MSN's search engine was not what the company had hoped it would be for the quarter.

Also, MSN's business is constructed more like AOL than Yahoo! or Google. In provides dial-up "narrowband" Internet access to customers. Revenue in that business has steadily declined as customers switch to broadband Internet access. That is no surprise to Microsoft, which has factored the decline into its projections, but it does serve as a drag on MSN as a division.

Microsoft hopes to boost revenue by launching Ad Center, which optimizes search results to advertisements. The product has been launched in France and Singapore and is being tested in the U.S.

The company also hopes that this will make MSN more competitive with Google and Yahoo!, both of which posted strong results for the quarter.

Fish or cut bait?

Drew Brosseau, an analyst with SG Cowen, said that while he feels the Microsoft versus Google and Yahoo competition is "wildly overblown," he feels there is no question that MSN is not executing as well as Google and Yahoo! to generate ad dollars.

"MSN is certainly important to Microsoft. They see a business opportunity to create a Google or Yahoo!-like business that would add to the growth of Microsoft overall," he said.

Mark Stahlman, an analyst at Caris & Company, said that the paid search space is not yet a "brutal, competitive slugfest," and that because the market is nowhere near being saturated, there is plenty of room for Microsoft, Google, Yahoo! and others to gain share.

Fulcrum Global's Friedman said because of this growth potential, Microsoft needs to make a decision about the future of MSN. Friedman believes one way to handle it could be for Microsoft to sell its search capability to AOL, which is well established in the content business. But regardless of what the company does, it needs to do it fast.

"They've got a problem," he said. "They need to either fish or cut bait. They need to exit or figure out how to fix it."

Christopher Hickey, an analyst with Atlantic Equities, agreed, saying, "I think it's an area where, unless they do something, they'll become a third or fourth place player -- and with Microsoft, that isn't a place they like to be."

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Friedman owns shares of Microsoft, but his firm has no banking ties to the company. Brosseau does not own shares of any of the companies he discussed, and his firm does not have banking ties to those companies. Stahlman does not own shares of the companies he discussed, and his firm has no banking ties to the companies. Hickey does now own sharees of Microsoft, and his firm has no banking ties to the company.  Top of page

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