About that $2B annual loss from Microsoft’s search business

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!

This entry was posted in Computer and Internet, Google, Microsoft, Search and tagged , . Bookmark the permalink.

26 Responses to About that $2B annual loss from Microsoft’s search business

  1. Sumit says:

    Good to know that OSD is planning to break even, but the major problem with Bing is ‘context’ of a search I believe Bing is very late to the part and no amount of blank checks are going to supplement ‘search context’ or relevance.

    Even when I am logged in to my Microsoft Account and using Bing the results are 75% of the time rubbish! Even duckduckgo returns better results for me (and it’s pretty easy to do just be better than stackoverflow’s own search engine and you’ve got most of my queries covered). However even queries with results from MSDN are returned better by other search engines than Bing itself.
    This leads me to believe, there is a technical bridge that Bing has to cross, it’s indexer is no way as fast or as well spread out as Google’s.

    I have finally gotten to a point where I refuse to give google any more of the ‘context’ from my side (use Bing and DuckDuck go as much as possible) but it’s tool late. Google simply ‘knows’ me better than ‘Bing’! Unless that gap closes fast, advertisement revenue growth will be a trickle and not a stream is what I suspect. And I don’t know how much search relevance will just sniffing Facebook and Twitter streams give.

    • Sumit says:

      All that said, giving up Bing is not really a serious consideration. Grinding forward is the only way to go…

    • I simply do not understand why people say the search results on Bing are so much rubbish. I use Bing and Google quite often and I have not had any trouble finding what I need on Bing. Typically when I can’t find something and search on Google, I get the same results.

  2. Bob - former DECie says:

    I had a similar problem a while back with irrelevant Bing search results when I needed to find out something about SQL Server Agent Job steps. I thought, “OK, this is a Microsoft product, let’s see what Bing can do for me” and did a Bing search. I don’t remember my exact search string, but it included “SQL Server Agent Job step”. What I got back was job postings for SQL Server DBAs and even call center telemarketing positions. I suspect that “SQL Server Job” triggered the DBA job postings and that “Agent Job” trigger the telemarketing job posting. It was at least 1 or 2 pages before I got and results related to SQL Server jobs. I took that same query to Google and got SQL Server job related results on the first page. And you are correct that Google seems to do a better job of finding stuff in MSDN than logging into my MSDN account and doing a Bing MSDN search.

    • Paul says:

      That exact query – SQL Server Agent Job step – works great for me on Bing today.

      • Bob - former DECie says:

        As I said, I don’t remember my exact query. At this point, I don’t even remember the problem I was having, so I may have included additional terms. The important thing is I had to wade through one or more pages of “junk” to get to results about a Microsoft product with Bing while Google gave me Microsoft product results on the first page.

  3. Mark says:

    Great article, as always. But not sure I agree with your conclusion on this one. Search hasn’t accomplished the objective they justified it on, namely creation of a major new profit center. And it doesn’t appear to have accomplished the secondary (primary?) objective of distracting Google. On the contrary, one of the most depressing things to watch is the relative ease with which Google has been able to rebuff the MS/Yahoo threat and simultaneously become the dominant OS provider in mobile, be on their way to duplicating that in tablets, and make significant inroads against MS in productivity. The only person who appears to have been hurt by this battle is MS. It has lost $15 billion and whatever opportunity it could have been pursuing instead. It hasn’t been able to gain share against Google at all. The business is still losing $2 billion a year. And Yahoo increasingly looks to be an unstable partner. Plus, everything has taken so much longer than expected that the entire economics have shifted, with people concerned about how even Google will maintain its profits in a world gone mobile. Even if MS is able to push through and get it to breakeven, do they really need another large but marginally profitable business like Xbox?

    • halberenson says:

      So what’s the alternative?

      • Mark says:

        I think you identified the available ones. I just think spinning it out is preferably to maintaining such a large distraction.

        I’m more concerned about what it says regarding MS’s process for new business development generally. Because there seems to be a disturbing pattern of MS getting into new areas without adequate forethought or competitive assessment and then losing a lot of money and years of effort before realizing it’s been a mistake. I realize it’s not easy to grow new businesses of the size MS needs to move the needle overall. However, it seems like MS has been disproportionately unsuccessful at it, in part because they don’t seem to learn from past mistakes.

  4. Tom says:

    Indeed. The economists have this weird notion that companies are supposed to maximize absolute profit. In actuality, companies maximize their profit **relative to** their competitors. If you spend $1 to cause your competitor to lose $2 in revenue, then your money hasn’t been wasted.

    That having been said — Bing *must* improve its search results for technical queries. I don’t care how great the Bing Challenge is doing among the general population — among developers, it’s no contest. Google wins. I start every fresh install of Windows with Bing as my default search engine, just to see if anything has changed since the last time I used Bing. I have never been able to go more than three days before switching to Google.

    Why? MSDN. The inability to retrieve relevant results from MSDN is the Achilles heel of Bing. When I switch to Google, they get not only my MSDN searches, but also all my other searches. What do Microsoft’s own developers use when they need to search MSDN?! I can’t believe they use Bing.

    P.S. Max Cleland is the former Senator from Georgia. The guy who wrote the article is named Scott Cleland.

    • halberenson says:

      Thanks for the catch. I must have had the senate on my brain 🙂

      MSDN has been a sore point since day 1. They really need to fix this.

      • Bob - former DECie says:

        I think MSDN has gotten worse since they’ve started returning results from various forums. It seems especially bad when I’m trying to look up the syntax of some language or .Net class library feature that I rarely use. I’d like a way to customize the source for MSDN searches so that I can limit the results to say just the MSDN documentation if I wish.

    • Alique Williams says:

      I completely disagree with your first paragraph.

  5. GrzeTor says:

    Notice that having a high-scale services divison also gets the owner know-how on how to run large-scale server operations. How to load balance traffic from hundreds of millions of users, how to divide processing in a distributed way etc, how to maintain such large infrastructure. This type of experience is not possible to get with classic, corporate customers, who have only thousands of employees on their corporate networks.

    • halberenson says:

      I certainly agree that Microsoft has learned a lot from the experience. And indeed Bing is likely to remain its bleeding edge experience with scale. Azure as a whole could eventually be larger, but no one Azure customer is likely to be in the same class.

  6. Great write-up Hal and I think you touched upon a lot of the key reasons why Bing is very strategic for Microsoft. I am not sure I agree entirely with you that Search traffic is moving off Google to these other experiences, and for a couple of reasons:
    1. A lot of attention is paid to the metric of Search marketshare, but what truly matters to the bottom line is the share of “monetizable” search queries, i.e. queries that advertisers bid on. While it has been historically difficult to get users to use you just for monetizable queries while they go to a generic Search engine for others (and therefore justifying the massive investments in the Search business), an Amazon is definitely changing that. A lot of those purchase-intent queries are starting off on Amazon, and therefore definitely impacting pure search Revenue. MSFT is not too well positioned to capitalize on this, even with their current investment in Bing.
    2. Search is also massively tied to distribution, and increasingly going Mobile – Google has a powerful brand and an expansive ecosystem in Android to serve as their moat. All of the investments you laid out center around Windows8, and therefore carries a significant (all-or-nothing) dependency on the adoption of Win 8 by Consumers…which is by no means a given. You allude to the Apple partnership at the end, but without something like that to continue keeping them relevant in the post-PC era, the battle will continue to get even more uphill for MSFT.

    • halberenson says:

      The problem for Search, which means for Google more than anyone, are that the trends are working against “web search”. Each Search Vertical has specialized apps, with Amazon as a perfect example. Both Google and Bing pour a lot of money into developing the shopping vertical yet so many people do exactly as you say and start their efforts at Amazon instead.

      Google is well positioned for Search traffice coming off of mobile, but its a much harder place to monetize.

      Microsoft has three consumer-focused platforms. Xbox, Windows, and Windows Phone. It must succeed with at least two out of three if it wants to continue to be relevant in the consumer market. ANd if those platforms aren’t succeeding then it really doesn’t matter what happens in the Search space as Microsoft will need to retrench and shift its entire focus to the Enterprise.

  7. gyurisc says:

    Very nice article as always, Hal!

    I am a Windows Phone user and I am very frustrated, because the search button on my phone is actually just a shortcut to the bing search portal (the Bing hardware button:)). I ‘ve been lamenting for a while now and asking myself, when will Microsoft implement the search feature properly on my phone, so it searches for information on my phone primarily and only fetching results from the web secondary like on the iOS platform.

    Your article drove me to the conclusion that this change might never happen…!

    • halberenson says:

      I’m not sure what the long term intent is with the search button. Recall that it started out as a context sensitive search, but for whatever reason that was dropped. If I had to guess I’d say that a future version of WP will implement Windows 8-style contracts and return the search button to the original context-sensitive intent.

  8. Excellent read! This game me a completely new perspective on Bing and it’s importance to Microsoft.

  9. halberenson says:

    BTW, I passed the general concern about Google being better than Bing for MSDN searches on to the Bing team. I’m frustrated because this is Deja Vu for me. In the early days of Live Search I was extremely active in providing feedback to the team, and as best I can recall this is the one area where they’ve failed to adequately address my concerns.

    • Bob - Former Decie says:

      Thanks, Hal. I’d love to be able to reliably search MSDN from MSDN.

    • I think that one of the main reasons why Google is better for MSDN searches is because it has a larger user base which, through their click-throughs, tell Google which links are better for each search query… This is something that Bing cannot “fix”. Better algorithms can only get you so far.

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