Microsoft Searches for a Google Killer

Microsoft's ( MSFT) strategy in the Internet search market not surprisingly reads like a well-worn page from the behemoth's playbook: Enter the market late, copy the early entrants and bundle with other Microsoft products.

But while Microsoft's latest moves into Internet search, unveiled late Wednesday night, certainly pose a threat to industry pure plays, they will have only an incremental impact on the world's largest software maker -- at least in the short term. Rather, investors and analysts see Microsoft's search maneuver as both a defensive play against Google and a step toward the next major release of Longhorn, the Redmond giant's operating system.

"I don't want to say it's not important, but then again I don't think it's critical-critical," Alex Vallecillo, a senior portfolio manager at National City Investment Management, said of Microsoft's search business. "It's not single-handedly going to drive the fortunes of Microsoft stock one way or the other."

Microsoft stock reflected this attitude, barely moving Thursday on the company's two-pronged Internet search announcement. Shares of Microsoft closed up 7 cents, or 0.3%, at $28.63. The news caused more damage to search engine rivals, with Yahoo! ( YHOO) shares, also pressured by an analyst downgrade, closing down $2.10, or 5.8%, to $34.30; and Ask Jeeves ( ASKJ) shares falling $3.35, or 8.6%, to close at $35.68.

Late Wednesday, Microsoft debuted a new, streamlined look for MSN search that looks remarkably similar to Google's uncluttered home page. That service is still using Yahoo!'s search technology.

And on another site, sandbox.msn.com, Microsoft offered the first sneak peek of its own new algorithmic search engine still under development. That service, expected to formally launch by the end of the year, was spotty Thursday, perhaps from too many users. A simple search for "polar bear" repeatedly came up with an error message, while other searches took several seconds to return results.

Although Microsoft is clearly late to the search engine game, that may not be important in what is increasingly becoming a commodity business, as one buy-side analyst suggested.

MSN's success in search to date, using Yahoo!'s technology, is a signal that search is becoming a commodity, noted the analyst, who holds Microsoft shares. Even with Yahoo!'s technology, MSN-Microsoft sites handled 15% of searches conducted by U.S. Internet users in April 2004, ranking third behind Google at 35% and Yahoo! at 30%, according to comScore Networks.

"I don't necessarily see it as hard to catch up," the analyst said. But "I think it's very difficult to build a competitive advantage."

Piper Jaffray analyst Gene Munster saw virtually no impact from search on Microsoft's business in the short term, but he said search will gain in importance in coming years.

That's because for now Microsoft's financials are primarily driven by its Office and Windows Operating System cash cows, which generated more than 60% of the company's revenue in the fiscal year ending June 30, 2003.

Even if Microsoft were to buy Google with its $961.8 million in revenue in 2003, that would boost the titan's sales by only 3%.

But search will be more important in 2006 when Microsoft launches its next operating system, Munster said. Longhorn is expected to feature a single tool to search both the Internet and a user's desktop, a function Microsoft has touted as a vast improvement over the woefully deficient search tool currently in Windows.

Munster believes that improved search function will be "one of the fundamental selling points of Longhorn" and consequently help sales in coming years. (Munster has an outperform rating on Microsoft and his firm hasn't done banking with the company.)

Standard & Poor's equity analyst Jonathan Rudy took a similar view. "As Longhorn gets closer to launching in 2006 ... Microsoft has got to demonstrate a need for consumers to continue to upgrade off of Windows and continue to provide value-added services," he said.

But Danny Sullivan, editor of SearchEngineWatch.com, doesn't believe that Longhorn's new search function will guarantee Microsoft's success or that such a bundling, which was pivotal to Microsoft unseating Netscape Navigator, will work with search. After all, Microsoft has already offered Internet search with its Internet Explorer browser and Windows for years and that hasn't stopped Yahoo! and Google.

"Overall, people migrate to the best service," he said. And even if Microsoft's new search tool offers a marked improvement on the desktop, he believes rival search engine companies would likely still find a way to piggyback onto the Windows application, just as Google found a way to add a toolbar to Internet Explorer.

Ultimately, Sullivan said he believes Microsoft can catch up and offer as good an Internet search engine as its rivals. "But I think it's going to be a real challenge for them to enjoy the kind of dominance they're used to having in other things they do," he said. "They're facing some well-entrenched competitors who are very smart themselves with very loyal customers."

In fact, Microsoft needs to play defense against a rival as canny as Google, whose upcoming IPO is the most widely anticipated offering this year. Google already has jumped into the email market, competing against Microsoft's Hotmail, and has announced plans to enter the desktop search arena.

"Google clearly has been more successful than Microsoft ever intended, much like Netscape before," Rudy said. (He has a buy recommendation on Microsoft and an affiliate of Standard & Poor's Securities has received noninvestment banking compensation from Microsoft.)

Investors today would probably find it hard to believe Google could face the same storied fate of Netscape, whose downfall amid Microsoft's bundling of Internet Explorer free with Windows postdated an IPO that was perhaps even more hyped than Google's upcoming offering.

But a look at what happened to another search engine player, Inktomi, illustrates that even Google's future is not assured, suggested Vallecillo. "When they were public about four or five years ago in their heyday, they commanded as much respect from analysts and the media as Google does today," Vallecillo recalled. "Analysts had all the conviction of the world that Inktomi had an insurmountable lead in that space, just as people now think Google's lead is insurmountable."

But at the end of 2002, Inktomi was bought by Yahoo! for a modest $235 million, or $1.65 per share. That was tiny fraction of the more than $200 a share fetched by Inktomi shares during the height of the dot-com bubble.

"In five years, who's to say there isn't somebody who is the new king of the hill in this space?" Vallecillo asked.

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