November 18, 2003 12:00 PM PST

Does MSN get the message?

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Microsoft's MSN online service reached an important milestone when it posted its first quarter of operating profitability--but that doesn't mean its problems are behind it.

The division reported $58 million in operating profit in the quarter ending Sept. 30, $48 million of which came from a one-time tax refund, according to a regulatory filing released last week. The remaining $10 million came from growth in advertising revenue, including income from paid search listings through a deal with Yahoo subsidiary Overture Services. MSN lost $147 million during the same period last year.

Microsoft executives talked up MSN's profitability as a sign that the long-troubled division is finally getting its house in order after years of red ink. Although the company only recently has begun to break out the unit's performance, analysts estimate it has lost billions of dollars since its launch in 1995.

"In the grand scope of things, they did get it profitable," said Alan Davis, an equity analyst at McAdams Wright Ragen. But "$10 million versus $50 million is not material in the big picture."

MSN could see further gains in the coming months if online advertising spending continues to recover. But it faces ongoing problems in other parts of its business, analysts pointed out, in particular its response to broadband and its shrinking dial-up access business.

Earlier this fall, Microsoft shuttered its digital subscriber line (DSL) offerings for consumers in SBC Communications and BellSouth markets. MSN previously leased DSL lines from these Baby Bells and resold them under its own moniker, while providing all customer service, billing and content for subscribers. Microsoft's new approach to broadband is to sell MSN as a software package to people using third-party cable or DSL services. The package, called MSN Premium, is expected to launch this winter.

These issues are not limited to MSN, but are industrywide. Microsoft rival America Online has reported staggering dial-up subscriber losses totaling nearly 2 million over the past year, while EarthLink's narrowband subscribers declined 3.4 percent from last year. AOL also is trying to sell its service as a standalone product to broadband customers.

Despite these losses, Microsoft executives are focusing on the positives.

"I think from a long-term perspective, senior leadership thinks it's vitally important to have a consumer presence on the Web," said Matt Rosoff, an analyst at Directions on Microsoft, an independent market researcher. "Even though (MSN) loses money, Microsoft can't withdraw because there must be some way to reach these consumers on the Internet."

Searching for dollars
What continues to work for Microsoft and many other Web companies such as Yahoo is commercial search. Without commercial search dollars, neither MSN nor Yahoo would be profitable.

MSN's advertising revenue shot up 50 percent from the previous quarter, largely from its relationship with Overture, which provides commercial search listings. While Microsoft does not break out Overture's contribution, executives say it's comparable to Overture's 20 percent contribution to Yahoo's revenue.

In a recent interview, one MSN executive who requested anonymity said the division's online ad sales, including paid search, will reach $1 billion in 2003.

Microsoft is investing heavily in developing its own search technology, having recently hired Paul Ryan, former chief technology officer for Overture.

Building off its financial success from search, MSN is developing a search empire to rival Google. Microsoft will invest $500 million to develop a system that will allow people to search the Web, desktop applications such as Microsoft Word and e-mail, and the operating system. Much of it will debut through its next operating system, dubbed Longhorn.

MSN has already begun the battle, having developed a homegrown Web crawler called MSNbot to create a search engine to challenge Google. On Monday, the company also launched a searchable index of online news in the United Kingdom and three other European countries in competition with Google.

Despite Microsoft's ambitions to take control of its own search destiny, the company has maintained its alliances with third-party providers including Inktomi and Overture, both owned by Yahoo. Since Yahoo bought both companies this year, industry watchers have expected Microsoft to drop their services. But last month, it extended its deal with Overture in the United States and the United Kingdom through June 2005. Instead, MSN severed ties with search provider LookSmart, which it paid to post its search results.

 

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