After the $6 billion aQuantive purchase, is advertising still the next big thing at Microsoft?

Jordan Golson — Fri, 18 Jul 2008 12:23:10 -0700

For years MSFT has sold computer software, including Windows and Office, making billions of dollars in profits for the company. However, as more and more products go online, and Microsoft gets into the search market (and makes a play for Yahoo) advertising is becoming more and more important. Why would a company want to buy Office and Windows for hundreds of dollars per seat, when they can use Google's near-equivalent for free?

This is not a hypothetical situation. The publishers of the Daily Telegraph in England are not renewing any of their licenses for Windows or Office -- they're transitioning to Google for most of their software needs, including email, calendars and collaborative writing through Google Apps.

So, how will Microsoft respond to upstart Google? I'd wager Microsoft will come out with a free, online version of Office in the next few years to compete with Google Apps -- and will sell ads -- or a premium corporate version -- to pay for it.

More and more tech companies that once derived their revenue from selling software or hardware or services are shifting to ad-supported models, with Microsoft and AOL being the most prominent. Microsoft CEO Steve Ballmer said last year that within a few years, he sees 25 percent of Microsoft's revenue coming from advertising.

Last year, Microsoft completed its acquisition of aQuantive for $6 billion. aQuantive, a massive digital advertising services company, brought Microsoft a lot of expertise and a huge client list -- both of which boosted the creation of an Advertiser and Publisher Solutions group. Brian McAndrews, CEO of aQuantive, was named to lead it. The group took control of almost all of MSFT's ad strategies from top to bottom. Microsoft believes the acquisition will help [Microsoft] build and support next-generation advertiser and publisher solutions.

But what did Microsoft get for their $6 billion? For FY 2008, Online Services Business (OSB) revenue was up 32 percent, to $3.2 billion. The OSB unit includes just about all of MSFT's ad units. It's unclear exactly how much of OSB's business is a direct result of the aQuantive acquisition, but in the fourth quarter, Microsoft attributes $94 million in agency revenue plus another $33 million from online advertising revenue to aQuantive. There is certainly more money coming from the aQuantive deal, but it isn't broken out in the earnings statements, making a final tally impossible to determine.

If the OSB is going to grow to 25 percent of Microsoft's revenue, it has a long way to go. Microsoft made $15.84 billion in sales last quarter, with just $838 million coming from the OSB group. The aQuantive acquisition helped a bit, but YoY revenue was only up 24 percent with the unit's operating loss more than doubling from $210 million to $488 million for Q4. MSFT blamed "increased cost of revenue [AKA partner payments to companies like Facebook and Digg] and other operating expenses" for the steep rise in loss. You've got to spend money to make money, I suppose, but at some point you're throwing good money after bad, no?

Microsoft is still making buckets of money from Windows and Office licenses and has plenty of cash to burn on building up its advertising services. Picking up Yahoo or AOL would certainly help them grow revenue, but perhaps not profits. Then again, Microsoft has a lot of smart people it could assign to run an acquired company and help them shape up.

Acquiring aQuantive was a good start but I don't think Microsoft can grow to become a massive ad company on its own. It will have to make another acquisition -- perhaps Yahoo, maybe AOL -- to make that happen.

A conversation I had a few months ago still sticks in my mind. A journalist who had been briefed on the subject told me that this advertising play is to get Microsoft through the current Web bubble. It knows that Windows and Office licensing is going to dry up eventually and MS has to survive to the next big thing, and grab control of that.

What is the next big thing? According to my source, Microsoft thinks it is interconnected devices. As wireless networks get more prevalent, everything in your home will be connected to the network. Your car, your refrigerator, your television, your iPod (Zune?) -- everything. Microsoft has its fingers in a lot of pies, with an in-car computer services partnership with Ford; Windows Mobile, which could be installed on a huge variety of platforms; set-top boxes; and many more. This vision is straight out of Bill Gates's mid-90's book, The Road Ahead -- just 20 years late.

Will Microsoft be 25 percent advertising company in 3-4 years, like Steve Ballmer predicts? Possibly.

But will Microsoft be an advertising company forever? Don't hold your breath. There's way more money to be made in software.

More news, commentary, and predictions from The Industry Standard:

Prediction: Microsoft acquires AOL
Analysis: An Open Letter to Steve Ballmer
Report: Microsoft in talks for a deal with AOL
Special Feature: Where are they now? The Industry Standard tracks down 10 dot-coms from the Web bubble of the late 1990s

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After the $6 billion aQuantive purchase, is advertising still the next big thing at Microsoft?