Microsoft Gets Stung by MSN Butterfly

The search business is looking like an albatross.
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A big part of

Microsoft's

(MSFT) - Get Report

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) - Get Report

and

Yahoo!

(YHOO)

. 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)

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.

Microsoft's MSN site had a 13% share of the search market in March, lagging behind Yahoo!'s 28% and Google's 43%, according to comScore Networks. The market researcher shows that MSN and Yahoo! both lost market share during that time while Google expanded its lead. Yahoo! has the most unique users, 123.8 million unique visitors in March compared with 116.1 million for MSN and 103.5 million for Google, according to comScore.

Neither Google nor Yahoo! will be willing to concede ground to Microsoft because there is too much money at stake. Demand for search, though slowing, remains strong as more local businesses shift advertising dollars online. Forrester Research estimates that U.S. search-engine marketing spending will hit $11.7 billion by 2010, a gain of 170% from 2004. During that same period, spending in Europe will jump 250%, to about $3.6 billion.

"The advertising and search market combined is growing at around 40% a year and it appears that MSN is significantly lagging behind the market," writes Piper Jaffray analysts Safa Rashtchy and Aaron Kessler in a note. "Yahoo! has beengaining share in advertising in the past year while Google has gained share insearch." Piper Jaffray has an outperform rating on Microsoft.

Shares of Google rose 35 cents to $420.38 while Yahoo! fell 4 cents to $33.16.