How Will Microsoft Snare Digital Ads?

Microsoft's Kevin Johnson talks about where the software king's online business is headed now that its proposed Yahoo deal is off the table

Microsoft still dominates the lucrative world of PC software, and it's one of just a handful of giants in the high-margin world of creating the software that runs servers for businesses. But there are few things more important in Redmond, Wash., these days than becoming a digital advertising powerhouse. Microsoft (MSFT) was willing to go so far as to spend $47.5 billion to buy Yahoo! (YHOO). The company walked away from that deal on May 3 when Yahoo held out for more.

But it has no plans to walk away from its online ambitions. That's because the company sees a huge threat to its core businesses from Web-based software programs, for word processing or collaboration, that are paid for by online advertising. BusinessWeek Seattle Bureau Chief Jay Greene spoke with Kevin Johnson, president of Microsoft's Platforms & Services Div., about the Yahoo deal and where Microsoft's online business goes next. Here are edited excerpts of their conversation:

Why does Microsoft have to be one of the leaders in digital advertising?

A couple of reasons. No. 1, today it's a $40 billion industry that's projected to double in the next two to three years, to an $80 billion industry. So it presents a significant growth opportunity for the company.

No. 2, the online advertising business is about software algorithms. It's about software that makes decisions within a millisecond of what ad to serve. It's software that manages massive amounts of data. It's software that provides workflow tools for publishers and advertisers. It's software that helps publishers optimize yield. It's software that helps advertisers maximize return on investment. A big growth opportunity, and it's a software business.

Then No. 3 is, as our core businesses start to expand into the world of software plus services, we will have a balance of business models. The software royalty model will continue. But it will be complemented with advertising-funded services and subscription services. And so we think it's strategically better for us [to be in the online ad business] than turning over the monetization of our online services to a third party, who may not have our strategic best interest in mind.

That third point is an interesting one because it suggests you see it as both an opportunity and a threat.

Well, I think certainly having an online ad platform is better to us than relying on a third party to provide that monetization. So strategically, it's important to us.

You and [Microsoft CEO] Steve Ballmer made a compelling case for the Yahoo acquisition when you first announced it in February. You said it would have made you much more competitive with Google (GOOG). So now that the deal is off the table, how do you get there?

In our display ad business, we are building scale. We're growing our page views. We have over 430 million users of our Windows Live service. These are active users. They use one or more of our services every month.

So from winning in display, we're now layering in things to help us differentiate. One is this concept called engagement mapping. It tells the advertiser, "Look, our platform has something Google doesn't have and Yahoo doesn't have. We're the only guys that have it." It gives the advertiser an end-to-end view of how they spend their money that's not all search. And they get some visibility to what ads are working and what's driving out.

The biggest question is around search. Advertisers say that, to spend more money on search with you, we'd like you to get more search share. Got it. To grow search share, without an acquisition, we have to deliver new and innovative approaches to search. If we're clever and we're creative, and we do it in a way that attracts consumers, we will grow share.

I've heard that same thing many times over the last four years with folks at Microsoft—saying we've got innovative new algorithms, we've got new approaches to search. And they were all interesting, and yet still, as you say, you plateaued. Is there a way to grow search without acquisition?

Yes.

And why hasn't the company been able to do it yet?

Well, some people look and say: Hey, we've been in the search business three or four years. Our competitor in the search business has been at it 10 years or so now. There's work that had to be done to get in the game. Doing that work, the relevance algorithms, the crawling of the Web, managing the size of the search index, that's the work that we've done over that last several years.

Now, our opportunity is how we build on that work in ways that start to change the user experience. You look at the user experience of search, it hasn't changed in the last five to seven years, by us or by our competitors. It's 10 blue links, and some paid listings on the right rail. So I think it's very clear to us that we've got to innovate in the user experience and the business paradigm in ways that are interesting to the consumer.

Is there any scenario in which you could see talking to Yahoo again?

We've moved on. We made a bid that we felt was a very good bid, full and fair offer, and went through that process, and that process has ended. A deal was not to be, and we've moved on.

You talked a bit earlier about engagement mapping. If it works and advertisers place more value on display ads, that could lower the relative valuation that search currently receives.

Right now, search gets more emphasis in the ad spending than perhaps it deserves. And all engagement mapping does is give the advertiser complete perspective to make thoughtful decisions. So I do think that engagement mapping is one way to enable advertisers to really be thoughtful about their investments. And if that attracts them to our ad platform, that's good for us.

But it also has the potential of disrupting Google, since it is far more dominant on search than display.

That's a fact. Google is more dominant on search than it is in display. And I think search gets more credit for conversion than it should. And engagement mapping is a tool that advertisers can use for them to be thoughtful about their spend on display and search.

So what's the impact on Google?

We'll see. Certainly by having tools like engagement mapping you might shift the share of spend. Advertisers may spend less on search, because they find they get more value on display.

Microsoft's history in the online business is mixed at best. Over the last three years, Microsoft has lost $1.5 billion in the Online Services Business division. The company went from sort of one strategy to another. It's also had these branding issues, trying to sort out the difference between MSN and Windows Live. So when you sit here and you say to me you have a strategy, you believe in it, there's a path to success, why should I believe you?

Well, it's fair to say we're not where we want to be. But we also recognize there's a big opportunity, and the opportunity before us is one that represents revenue and profit growth for our shareholders. And it's one that provides strategic value to our other core businesses as we balance from software royalty to online advertising business models.

And so I think in many ways, this strategy that we have now is very similar to what we've learned in other parts of our business. You've got an underlying platform that you want to have value for your own applications as well as third parties, and that's what the ad platform does.

We're making progress. If you look at our top-line ad revenue growth, we've outgrown the industry for at least the past four quarters. It is fair that we are investing, and we're investing in this for the long term. We intend to build online into a core business. It will require investment. And so we are investing dollars in things that are aligned with our strategy, and we're making progress. But we've got a lot of work to do.

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