A few days ago Scott Cleland published a thought-provoking piece on what would happen if Microsoft exited the search business. It was all about what that would do to Google, but might just as well have been titled “Microsoft should risk mortally wounding itself just to spite Google”. So I wanted to address the “$2B” annual loss as well as the strategic benefits of Microsoft’s participation in Search and the implications of Microsoft exiting the search business.
Let’s start with the financials behind Microsoft’s Online Services Division (OSD). This division covers Bing, Advertising, and MSN. These days MSN is primarily a search-based portal, so I think we can just lump it together with Bing. So OSD is the Search and Advertising business. When Microsoft got serious about going after the Search and Advertising space it got really serious and basically started writing blank checks. It wrote checks to PC makers to make Bing the search default and install the Bing toolbar. It wrote checks to acquire companies, at somewhat insane prices. It began a large-scale layoff program in its traditional businesses, one much larger than necessary to deal with the recession, so it could massively increase OSD (and a few other areas’) staffing. And it did a deal with Yahoo that sent Yahoo cash in excess of what it would get from actual advertising revenue to ease Yahoo’s transition from its own platform to Bing.
Why did Microsoft go so crazy on Search and Advertising? Well for one thing Search had become core to many usage scenarios, both online and on computer systems. With Google’s ambitions to compete with Microsoft across the board (operating systems and productivity tools being two major examples) Microsoft needed to get Search from someone else. And everyone else was failing. So strategically Microsoft needed to step up in some way. You could imagine Microsoft having found an alternate way to do this, but in every case Microsoft would have in effect been outsourcing its future.
Microsoft had also taken note that Google’s search-based advertising business model was as outstanding as Microsoft’s own model had been in the 90s. Microsoft wanted a piece of that pie. Finally, every dollar of ad revenue that goes to Microsoft, and every bit of extra R&D or marketing spend that Google has to devote to defending its Search and Advertising business against a strong competitor, is a dollar that Google can’t spend going after Microsoft’s other businesses. So for Microsoft, being a strong number two in Search and Advertising should be a win/win/win.
The reason Google’s business model works so well is that it’s based on a bidding system. The more eyeballs you have the more advertisers want to get to those eyeballs. The more advertisers bid for those eyeballs the higher price you get (either for clicks in Search or impressions in Display advertising). As your user and advertiser base grows your costs grow linearly while your advertising revenue increases exponentially.
In theory all Microsoft had to do was spend a huge amount up front to reach a magic point on market share and from that point on it would benefit from Google-like economics with linear cost growth but exponential revenue growth. The Yahoo deal was supposed to get it across that threshold, but you don’t see it in the numbers. Microsoft is seeing revenue growth, but not the explosive growth one would expect at this point.
Will Microsoft ever see the Google-like economics that were so tempting back in the mid-2000s? If it does then it likely won’t be from classic web search. The search battle has moved on to other areas, and I’ll get to that later. As is usual in these kinds of battles, the head-on attack against a dominant competitor yields at best fractional gains (unless the competitor screws things up and creates a big opening). So Microsoft can continue to gain market share with Bing web search, but at such a slow pace that it hardly matters. Those who over-focus on this come to the conclusion that Microsoft should exit the search business. They are simply focused on the wrong thing.
On the cost side OSD is suffering from both ongoing startup costs as well as the cost of pursuing numerous end-runs around Google. But if you look at the numbers you can see Microsoft has been working hard to get the startup costs behind them. They are almost done with the payments to cover Yahoo’s switching costs. And other expensive deals to acquire traffic also seem to be expiring, or entering a phase where guarantees beyond sharing of actual revenue are expiring. The high initial spend to establish the Bing brand also appear to be behind them, with Sales and Marketing expenses down 23% in Q1. R&D spend continues to grow, but at a slower rate than ad revenue is increasing. Several more quarters like this and OSD will break even. Yes OSD lost $2B in FY12, but that loss will shrink significantly in FY13.
But is focussing on these losses important? Maybe not. Let me call your attention to this sentence from Microsoft’s most recent (at least until next week) 10-Q: Due to the integrated structure of our business, certain revenue earned and costs incurred by one segment may benefit other segments. This allocation problem is one that all businesses face, but it is a big one at Microsoft. Revenue allocation is simple compared to cost allocation. For example, when Microsoft Access was owned by Developer Division but shipped in Office Professional you had to figure out how much of an Office Pro license to allocate to Access. You could simply say that Access deserved to be allocated all of the price difference since it was the only difference between Standard and Pro, or you could argue that since Enterprises tended to buy one edition for the entire company that you should base the allocation on actual usage of Access. Either way, Access was allocated revenue out of an Office sale. The same thing happens today with Core CAL and ECAL.
But what happens if, for example, SQL Server spends a few man-years implementing a feature that Windows Live, or Office, or Bing, or XBox request? Do those costs get allocated to the requesting business? Generally not. They are absorbed by the SQL Server business and appear in the Server and Tools segment of the financial statements. Even during something as massive as the WinFS effort it isn’t clear how much of the R&D costs accrued to which business. While it would have been possible to roll up the explicit WinFS team spend to Windows, the SQL Server team itself was doing a lot of work in support of WinFS and those costs would have accrued to the SQL Server business.
Bing is central to the XBox experience. Bing is central to Windows Phone. And Bing is central to Windows 8. Take the set of free Bing-based apps that appear on and make Windows 8 attractive, like News. Bing wrote the apps and incurred the R&D expense. They incur the expense of operating the back-end. They incur the expense of curating the content. And that expense is part of the OSD segment in the financial reports. How can I be sure they aren’t allocating it to the Windows and Windows Live segment? Each app has some small amount of advertising in it. Scroll through a level of stories and you’ll find a single display ad at the end. It likely won’t generate enough revenue to make a dent in costs associated with the apps, but it does make it crystal clear where financial responsibility lies. Even without the ads the costs probably would accrue to OSD, but the ads leave no doubt.
A significant amount of the costs associated with OSD are the result of spending that ultimately brings revenue to other business segments. Is there method to this apparent madness? Well yes, in multiple ways. Just looking at it from OSD’s business perspective these activities are part of its ongoing efforts to find end-runs around Google’s search dominance. Its Windows 8 apps represent many of the top categories that people typically do with web search. Someone using those apps is reducing their use of web search, and given Google’s dominance in web search is likely reducing searches done on Google. If you are using Bing to find movies on your XBox, Bing to find restaurants on your Windows Phone, and Bing apps to read the news, research travel, and follow stocks on Windows 8 how long until you consider yourself a Bing rather than Google user? Oh, and throw in that you are using Bing as part of your searches on Facebook.
Indeed most users in the world are probably occasional users of Bing, even though most of their explicit searching is done with Google. And forget all those monthly measurements of Search market share, they probably don’t capture all this indirect activity. The Microsoft strategy will move a lot of search traffic off of Google and onto Bing. The trick for OSD is to figure out how to monetize it.
While OSD hasn’t yet turned all this cost into an exponentially growing revenue stream Microsoft as a whole is benefiting mightily by having Bing as a strategic asset. A few weeks ago I caught an episode of a TV show I hadn’t seen and decided I wanted to watch the series from the pilot forward. A Bing search on my Xbox 360 found the first season was available on Netflix but the current season would have to be paid for on Xbox Video or Vudu. I’m a few shows from being caught up on season two. Bing made the Xbox experience great, enhanced the value to Netflix of being on the Xbox, and brought the Xbox business some direct video rental revenue. Did OSD see any revenue out of this? I doubt it. Though they probably did gain some personalization information that will allow more effective advertising to me on the Xbox 360 Dashboard, and thus eventually some revenue.
Bing News is my single most heavily used app on Windows 8. It was the first thing to give me that “wow” experience on the platform. I think they are carefully keeping advertising unobtrusive right now, but eventually OSD could find ways to get real ad revenue from this and other apps.
So where is Microsoft on Bing? I think the top positioning of Bing at the CEO, Board, and Senior Leadership level is that it is a strategic asset that is to be used as a core part of the user experience across all Microsoft products and services. It is also something that can generate significant profits in the long-term, but that is no longer as central to Microsoft’s growth story as it was believed to be back in the mid-2000s. As such OSD is now more focused on reaching break-even within several quarters than on spending extravagantly to buy market share. Market share, or rather better opportunities to sell advertising, will come with the increased usage through the overall Microsoft user experience and not from web search. And eventually shareholders will find themselves happy with Microsoft’s investment in Bing.
Now what if Microsoft were to exit Search as proposed by Scott Cleland and others. The first thing is that it is silly to think that Microsoft could just announce one day that Bing was shutting down. They have contracts with people like Yahoo and Facebook that would need to be honored. They’ve integrated Bing into all those user experiences, and by all reasoning they are working on even greater use of Bing as a central part of future experiences. Before they could shut Bing down they’d have to find an alternative, and there are none! Just shutting down Bing might put Google in a regulatory hell equivalent to what Microsoft experienced in the 90s, but it would also seriously and perhaps mortally wound Microsoft itself. So a Microsoft exit from Search would not be via shutdown, it would have to be via spinoff into an entity that they could rely on. Forget Cleland’s scenario, it is nonsense.
A scenario that could work would be to spin Bing off into a joint venture that Microsoft co-owned with Facebook, Yahoo, and perhaps others (e.g., Apple). Microsoft would retain sufficient ownership to protect its strategic interest in the technology, but trade away the future ability for advertising to become a huge profit generator in exchange for reducing short-term costs. There are only two problems with this scenario. One is that JVs are notoriously difficult to make work and putting one in the middle of something as strategic as Microsoft’s overall user experience is suicidal. Second, if Microsoft is already on a path to get OSD to break-even what would really be the benefit of such a JV? Maybe if it brought Apple on board it could change industry dynamics enough to make a JV interesting. But otherwise I think a JV or other spinoff of Bing doesn’t make strategic or even financial sense.
Bing remains important to Microsoft’s future, though perhaps more for its value as a strategic technology asset than for any expectations of explosive revenue and profit growth. Microsoft will get OSD to break even in the next several quarters, which will at least make it less of a whipping boy. And they continue to think that some day it will produce substantial profits. But anyone who is focused on if and when that happens is, in my opinion, missing the point.
And with that I end what very well may be my longest blog post to date!