There were two interesting pieces of news out this week.  One was news from Experian Hitwise adding to other evidence that by some measures Bing has grown to about 30% of the search market in the U.S.   The second interesting piece of news is that Google reported disappointing earnings.  Are these two pieces of news related?  I doubt it, but they do leave Google between a rock and a hard place.  I’ll go a little into Bing’s rise and why Google now has a real problem on its hands.

If you go back four years ago Microsoft had put version one of Bing (then known as Live Search, having recently been renamed from MSN Search) into the market and elevated that effort from having a supporting role in MSN to being a first class initiative of its own.  At the time Live Search had a very small market share, mostly driven by users of its MSN portal.  Microsoft faced a huge set of hurdles in its attempt to go from a distant 3rd in the search market to a strong 2nd (and perhaps someday a real challenger for the #1 position).

Hurdle #1 was the poor performance of its core search engine.  Live Search just produced horrid results compared to Google and that was immediately obvious to any user.  The experience with Google was that you asked a question and links to the answer were at the top of the page.  Sometimes it seemed like Google read your mind.  The experience with Live Search was that you got an answer related to the words you typed but not necessarily the links that you were looking for.  So Microsoft threw huge resources into improving its core search engine performance, which is now in the same league as Google.  Both companies will continue to invest in improving their core search engines, but it is unlikely that either will be able to get sustainably ahead of the other in the future (unless someone screws up and dis-invests in core search).

Hurdle #2 was finding a way to change the search experience.  Just creating a search engine that was “as good as” Google wasn’t likely to bring users to Bing.  Microsoft needed to change the definition of search and make the experience very different.  It couldn’t be yet another search page that provided “10 blue links”.  You can see this evolution accelerate over the last four years, starting with the amazing background image that Bing displays on its homepage each day.  People go to Bing just to see that image.  People use screen savers that grab those images.  Then Bing focused on being a “Decision Engine”, helping people get the answer they were looking for rather than just a set of links.  And if you want to see the latest step take a look at the new Bing for iPad which is almost a shell you want to live in all day rather than just someplace you go to search.  I don’t think Microsoft is done redefining the search experience to be a Bing experience rather than a Google experience, but they’ve made good progress.

Hurdle #3 was addressing the marketing and (particularly) distribution problem.  Let’s just start with the name “Live Search”.  Google had become a verb.  How do you tell people to “Live Search it” instead of “Google it”?  You don’t.  So Microsoft went looking for a rebrand that would be catchy, could serve as a verb, etc. and landed on Bing (which I think ended up being perfect).  But there was a more immediate problem.  Google (as well as Yahoo) was paying computer manufacturers, printer manufacturers, high volume software providers, and everyone else they could think of to set the search default in the browser on PCs to be theirs and to distribute their toolbar.  And they were actually making it difficult for another piece of software to reset the default.  So a very large portion of the searches that Google was getting were from these default settings rather than from the user explicitly going to Google.  And then the user gets used to Google, so even when they go to a search engine home page it is Google’s.  Microsoft had to get its own search defaults and toolbar out there.  While it could do some of that via its existing mechanisms (e.g., when someone downloads Windows Live  or MSN you could include the toolbar and offer to set the search default to Bing) it needed to start to compete for search default/toolbar deals with third parties.  Eventually Microsoft won distribution deals with HP, Sun (for the Java installer), Dell, and others.  Microsoft effectively was able to declare victory here.  These deals are expensive, and no doubt represent a significant portion of the losses that Bing contributes to Microsoft’s bottom line.  And that is where the next item comes in.

Hurdle #4 was critical mass.  This is the crucial one because it is really all about search economics.  Search Advertising is an auction system.  Advertisers bid to have their links displayed at the top of the search results whenever results for a particular keyword appears.  As in any auction system, the more bidders there are the higher price you have to pay for your ad.  Google has such high search market share that everyone wants to advertise there, while Live Search had such low market share that there were few advertisers.  A keyword on Google might command $10 per click to be the first paid link displayed.  That same keyword on Live Search might have commanded only $2.  Microsoft had to, and I’m not sure they’ve done it yet, attract enough advertisers to get the price per click up to comparable levels with Google.  This is important for two reasons.  The first is just the obvious business point that if your revenue = clicks * price-per-click that financially you want to grow both clicks and price-per-click.  But more specifically, think of things like those search distribution deals.  Take an extreme example and say that Google was offering to give a PC maker 50% of its click revenue from the PCs they sell, or $5 per click.  Now Microsoft has to match that to get the deal, but Microsoft is only taking in $2 per click.  Microsoft would lose $3 every time someone clicked on an ad!  So Microsoft had to get more advertisers, which would drive the price-per-click up and make Bing financially viable.  But with 5-10% market share that just wasn’t going to happen.  I can tell you that when I was doing PredictableIT I stopped our advertising campaign on Live Search because although the price-per-click was low I was getting just about no clicks.  So I just concentrated my effort, and budget, on Google and Yahoo.  Microsoft went looking for an answer to this problem and settled on a search deal with Yahoo.  With Bing powering Yahoo-search, and a joint effort to sell search advertising, Microsoft’s market share would be high enough to attract advertisers and drive the price-per-click up.  Yahoo using Bing for search, and the joint advertising effort, have been in operation for only about 6 months so it is too early to know if it is working on the financial front.  But as market share rises the economics should look increasingly good for Microsoft.  At a minimum they should do well enough to continue the fight, and that’s where things get interesting given Google’s latest financial results.

The big issue in Google’s latest financial results is that they are experiencing margin pressure because of a spike in expenses.  Fundamentally, Google has just one significant revenue stream (Search Advertising) but is investing wildly in other areas.  It is investing in a suite of applications (Google Apps) to compete with Microsoft Office.  It is investing in two operating systems (Android for phones/tablets and Chrome for PCs and perhaps tablets).  In is investing in and running a free VOIP phone service.  And it is trying hard to find a way to compete with Facebook in the social networking space.  And none of these things directly result in significant revenue.  Google doesn’t want to drop these investments because in the long-term that would leave them even more dependent on the classic PC web search advertising business.  But at the same time, with Bing’s market share growth, and its apparent success in starting to redefine Search, Google has to put more focus (and likely spending) on its key business.  Not only that, but as advertisers find Bing a place to put a larger percentage of their ad budget, Google will see its price-per-click drop.  By keeping up the pressure Microsoft can make it increasingly difficult for Google to maneuver without it going into a financial tailspin.

The real question here is what can Google do to directly defend itself in search?  Well, more innovation, including redefining Search itself, is one answer.  The problem is that Google would then risk alienating its customers (think: New Coke) and giving them more reason to try, and perhaps stick with, Bing.  Another is to compete to win back search deals (and deals for its other offerings, such as the Chrome web browser) as the default on various PCs.  The problem here is that Bing’s increased market share means Microsoft can force the bidding even higher, causing Google to pay so much that it achieves a pyrrhic victory.  The bottom line could be that Google’s days of ever-increasing market share and “obscene” profit margins may be coming to an end.

But I do want to get real here.  Google’s worldwide market share is as dominating as ever, they have a loyal customer base, and “Google” is still a verb.  Google needs to keep in mind that if they stumble Microsoft is right there and well positioned to take advantage of Google’s woes.  And that is exactly how Microsoft has defeated market leaders in the past.