How Will Microsoft Snare Digital Ads?

Microsoft's Kevin Johnson talks about where the software king's online business is headed now that its proposed Yahoo deal is off the table

Microsoft still dominates the lucrative world of PC software, and it's one of just a handful of giants in the high-margin world of creating the software that runs servers for businesses. But there are few things more important in Redmond, Wash., these days than becoming a digital advertising powerhouse. Microsoft (MSFT) was willing to go so far as to spend $47.5 billion to buy Yahoo! (YHOO). The company walked away from that deal on May 3 when Yahoo held out for more.

But it has no plans to walk away from its online ambitions. That's because the company sees a huge threat to its core businesses from Web-based software programs, for word processing or collaboration, that are paid for by online advertising. BusinessWeek Seattle Bureau Chief Jay Greene spoke with Kevin Johnson, president of Microsoft's Platforms & Services Div., about the Yahoo deal and where Microsoft's online business goes next. Here are edited excerpts of their conversation:

Why does Microsoft have to be one of the leaders in digital advertising?

A couple of reasons. No. 1, today it's a $40 billion industry that's projected to double in the next two to three years, to an $80 billion industry. So it presents a significant growth opportunity for the company.

No. 2, the online advertising business is about software algorithms. It's about software that makes decisions within a millisecond of what ad to serve. It's software that manages massive amounts of data. It's software that provides workflow tools for publishers and advertisers. It's software that helps publishers optimize yield. It's software that helps advertisers maximize return on investment. A big growth opportunity, and it's a software business.

Then No. 3 is, as our core businesses start to expand into the world of software plus services, we will have a balance of business models. The software royalty model will continue. But it will be complemented with advertising-funded services and subscription services. And so we think it's strategically better for us [to be in the online ad business] than turning over the monetization of our online services to a third party, who may not have our strategic best interest in mind.

That third point is an interesting one because it suggests you see it as both an opportunity and a threat.

Well, I think certainly having an online ad platform is better to us than relying on a third party to provide that monetization. So strategically, it's important to us.

You and [Microsoft CEO] Steve Ballmer made a compelling case for the Yahoo acquisition when you first announced it in February. You said it would have made you much more competitive with Google (GOOG). So now that the deal is off the table, how do you get there?

In our display ad business, we are building scale. We're growing our page views. We have over 430 million users of our Windows Live service. These are active users. They use one or more of our services every month.

So from winning in display, we're now layering in things to help us differentiate. One is this concept called engagement mapping. It tells the advertiser, "Look, our platform has something Google doesn't have and Yahoo doesn't have. We're the only guys that have it." It gives the advertiser an end-to-end view of how they spend their money that's not all search. And they get some visibility to what ads are working and what's driving out.

The biggest question is around search. Advertisers say that, to spend more money on search with you, we'd like you to get more search share. Got it. To grow search share, without an acquisition, we have to deliver new and innovative approaches to search. If we're clever and we're creative, and we do it in a way that attracts consumers, we will grow share.