July 26, 2004

At an October 2002 celebration to introduce Microsoft's MSN 8 Internet service, Bill Gates showed a video of himself wearing a butterfly costume and handing out software for the search service.

His point was that after seven years of floundering in the Internet access market, Microsoft would do whatever it took to beat its longtime rival America Online.

That included pouring $500 million into MSN to match AOL's most popular features and another $300 million into marketing, featuring MSN's butterfly mascot and a concert highlighted by rocker Lenny Kravitz singing "Fly Away."

But all that flew away was the better part of a billion dollars. Microsoft's share of the Internet access market has declined steadily since.

In the years since the start of what was first called the Microsoft Network, Gates has tried dozens of business models, from Internet access to Web sites to monthly software subscriptions.

They all had one thing in common: they lost money. Over the last year, however, MSN has finally started to see some profits.

The unit began making money last fall and is expected to post an operating profit of about $200 million for the fiscal year that ended June 30, compared with a loss of about $531 million last year.

The reason has little to do with any of Microsoft's more ambitious Internet strategies. Instead, it was one of the businesses that it had put on the back burner -- Internet advertising -- that really started to take off.

Even without a lot of new investment, MSN's Web site has long been the third most popular destination on the Internet, bringing together its Hotmail e-mail service, the MSNBC news operation and a variety of other channels.

Recently, it has worked to repair a frayed relationship with Madison Avenue, putting the company in a good position to gain as the ad market rebounded. Over the last year, MSN has ranked second in online advertising revenue, behind Yahoo and ahead of the longtime leader AOL, a unit of Time Warner.

Mary Meeker, the Morgan Stanley Internet analyst, said that MSN's revival was an indicator of the company's trademark doggedness.

"They began their attack on AOL 10 years ago," she said. "Since then they have lost billions, and now they are making money. It gives me a real sense of just how patient they are."

Now basking in its newfound profitability, MSN is again on the offensive, competing with Yahoo, the Internet portal, even more than with AOL.

It has a three-prong strategy: continue to cash in on the advertising market, sell software services for people who have broadband Internet access from cable or phone companies, and build a better Web search engine.

MSN, which uses Yahoo's search technology, is trying to develop search technology to take on Google. It hopes to introduce that technology by the end of the year.

As investors consider Google's public stock offering, some worry that Microsoft will be able to squeeze out the plucky search company just as it pushed aside Netscape in the Internet browser market. After all, it plans to include links to its new search service on the Windows desktop and in many other products and services.

Yet that same considerable Windows advantage led many observers to predict that Microsoft would cause more trouble than it actually did for AOL and Yahoo. It turned out that most Internet users were willing to skip past the default services offered by Windows in favor of brands they preferred.

"There was a concern that Microsoft would always win because they owned the desktop," said David Card, the research director of Jupiter Research. "If the desktop is so important, then Microsoft should have beaten AOL, but they didn't."

One drag on MSN over the years, said several people who worked there, is that Microsoft has been conflicted about whether to treat the Internet as a media business or a form of software. It is not a simple either-or proposition because so much of the Internet is a hybrid -- free software paid for by advertising.

"One thing that amazed me is that the organization changed annually," said Merrill Brown, the former editor in chief of MSNBC. "They seize upon a good idea, and throw lots of resources at it until it's time to move to the next idea or acquisition."

Microsoft certainly has had some successes on the Internet, including Hotmail, MSNBC (a joint venture with General Electric), the Slate opinion journal and Expedia, the online travel agency it sold to InterActiveCorp.

But there have been at least as many failures, ranging from Mungo Park, an adventure travel site, to the CarPoint automobile buying service, to the controversial Hailstorm system for connecting information from different Web sites.

But Microsoft's biggest online failure has been its Internet access business. It lost several billion dollars over the years by paying people $400 rebates to sign three-year contracts for MSN dial-up accounts, according to Internet industry executives. Those customers have quit the service in droves as their commitments expire.

By contrast, AOL's Internet access business has been hugely profitable, even amid turmoil from its merger with Time Warner and the decline in the dial-up, or narrowband, market.

"We said that narrowband is like the buggy whip business," said David Cole, the Microsoft senior vice president in charge of MSN. "We could try to be the best buggy whip maker, but that's not very aspirational. It's hard to get people rallied around that."

The broadband market, however, has proved exasperating for dial-up providers like MSN, AOL and Earthlink, all of which wanted to buy high-speed connections wholesale and market them to consumers.

After accounting for the customer acquisition costs, the costs paid to telephone companies and the support costs, Cole said, "there is nothing left over."

Microsoft has invested $6 billion in Comcast, the nation's largest cable company, but that has not led to an arrangement to distribute MSN services to Comcast customers. Comcast, in fact, edged out Microsoft this year to become the nation's second-largest Internet provider, with 10 percent of the Internet access market, according to Solomon Research.

Microsoft's share o that market has fallen from a peak of 13 percent in 2002 to 8 percent today. (AOL's share fell to 24 percent from 29 percent in the last two years.) Microsoft claims a total of 8 million subscribers to its various MSN services, of which about 5 million are Internet access customers, according to ComScore Media Metrix, an Internet ratings company.

Now, the company hopes to sell extra services to people who buy broadband service from their local telephone or cable companies. For $5.95 a month, it offers MSN Plus, which mainly expands e-mail services. MSN Premium, for $9.95 a month, adds firewall and virus software, and access to some proprietary content, most notably Webcasts of Major League Baseball games. Microsoft paid a reported $40 million over two years for the baseball rights.

So far, that market has not taken off. Microsoft will not say how many broadband add-on subscriptions it has sold, admitting only that the vast bulk of its users come from deals it has struck with Verizon and Qwest to include MSN software as part of those company's basic broadband services.

Microsoft is also developing more services, including some for small businesses, and a new music download offering meant to compete with Apple's iTunes.

But it is MSN's advertising business that is really starting to pay off.

The company had a reputation on Madison Avenue of being unresponsive and forcing advertisers to use its own proprietary formats. But in late 2001, it hired an experienced magazine executive, Joanne Bradford, to run its advertising sales staff and to reach out to agencies. It also moved to embrace the industry's standard ad formats. As marketers discovered ways to use more interactive ads, MSN was one of the few sites that could deliver a mass audience.

Still, MSN's audience appears to be more transient than those of its rivals. According to ComScore Media Metrix, 111 million people visited some part of MSN at least once in May. That is just slightly behind Yahoo, which had 113 million visitors and Time Warner (including America Online), which had 112 million. But MSN's visitors spent 147 minutes, on average, looking at MSN pages in the month, far less than the 260 minutes that users spent on Yahoo or the 340 minutes they devoted to Time Warner sites.

Yusuf Mehdi, a vice president for MSN, concedes that the company needs to find a way to engage its audience more.

"We want to have the sort of evangelical feedback that people have for the iPod or the TiVo," Mehdi said. "I want people to say, 'I love MSN.'"

MSN hopes one way to achieve that is to customize its service to the interests of each user. For example, it has introduced trial versions of an automated news service that displays headlines for articles based on the topics that users have shown interest in.

Another part of Microsoft's Internet strategy is to combine Web searches with an improved application that lets users find documents and e-mail messages on personal computers. The enhanced search function will be a feature of the next major version of Windows, scheduled for 2006, but Mehdi said that MSN would make a desktop computer search feature available much sooner, probably as part of the free downloadable toolbar that it introduced earlier this year. And last week Microsoft bought Lookout, a tiny software company, to help with its desktop search effort.

But even with this new focus on searches, Danny Sullivan, the editor of Search Engine Watch, said that Microsoft will have a tough time catching up with Google. "To shift market share, Google has to get bad and they have to get good," he said. "People will not go to Microsoft, even if Microsoft is better than Google -- if Google is good enough."

Mehdi said that Microsoft was betting that none of today's search engines are quite good enough to hold users and that Microsoft's strengths will give it a significant advantage as the Internet evolves.

"Search is not done until you can give users the answer they want instead of a list of 1,000 Web sites," Mehdi said. "That's a big, tough software problem. And we said, thank goodness we're software guys."

Source: San Mateo County Times

        

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