Microsoft Gets Stung by MSN Butterfly

A big part of Microsoft's (MSFT Quote) mess is its also-ran MSN search engine.

Shares of Redmond, Wash.-based Microsoft plunged 11% Friday in the wake of Thursday's soft quarter and tepid guidance. The world's largest software maker attributed the miss to heavy spending in a number of areas, including the Xbox 360 product costs, accelerated hiring, more R&D and heavy marketing as the company prepares for the launch of Vista, the new version of its flagship Windows operating system.

But another key factor in Microsoft's surprising shortfall was the rising cost of competing with the better-positioned Net players, notably Google (GOOG Quote) and Yahoo!(YHOO Quote). Wall Street knows Microsoft is spending freely to play catch-up when it comes to its MSN search engine, whose corporate emblem is a multicolored butterfly. But Thursday's setback makes clear just how tall the task is going to be.

"Search investment at Microsoft is not new news, in our view, and has been anticipated by both Google and Yahoo!," writes Merrill Lynch analyst Justin Post in a note to clients. Merrill Lynch rates Microsoft as neutral. "Despite investment, we expect Microsoft to continue to lose advertising share in CY06 (search revenues were down in C1Q). Microsoft indicated management would discuss its MSN division investment plans in more detail at its July 28th analyst day, and competitive investment will continue to be an investment risk for the sector."

Indeed, Microsoft has made no secret of its desire to grab its share of the exploding market for Internet advertising. Last week it hired a new chief for MSN -- Steve Berkowitz, who is credited with turning around IAC/InterActiveCorp's(IACI Quote) Ask.com business.

MSN has recently gotten kudos for the launch of its new AdCenter ad buying program that allows companies to target their messages to specific demographic groups. But that service isn't going to be enough to improve MSN's performance, analysts say.