Microsoft reinvents itself again

Live Search update plus recent acquisitions could turn Wall Street into MSFT believers once again

Microsoft is reinventing itself yet again, building out from its core desktop-franchise to stronger positions in online advertising, search, and to a lesser extent, consumer electronics. Sure, Microsoft has stumbled in every one of these areas, but with the deepest pockets in the industry, Ballmer & company have the resources and the mental toughness to try and try again. Remember Netscape? You get the point.

Wall Street is eager to see Microsoft break out. Despite significant top- and bottom-line growth, a decent dividend, and a CFO who is popular with the analyst community, the stock has been stagnant for years. During the past 24 months, shares have appreciated by about 11 percent, roughly half the gains of the tech-heavy Nasdaq. And by another key measure as well, the stock is actually cheaper than its peers, trading at about 20 times forward earnings. (Twenty-five times would be closer to average.)

Two big reasons investors are skeptical:

• Microsoft’s inability to make money beyond the desktop. Online services brought in a paltry $688 million in the June quarter and managed to lose $239 million, while the entertainment and devices division lost $1.2 billion on revenue of just under $1.2 billion. In other words, Microsoft lost a dollar for every dollar of revenue the division brought in. Yikes.

• Fears that Google and the Web 2.0 crowd could make desktop applications obsolete as the world moves toward software as a service.

In the last week, though, the boys and girls from Redmond have rolled out the first major update in a year to Live Search; the acquisition of Jellyfish, a comparative shopping site; and a new version of the Zune digital media player. And last spring, you’ll remember, it paid $6 billion — the company’s biggest ever acquisition — for aQuantive, a pricey but smart move designed to bulk up its ability to serve and sell online ads.

The changes to Live Search were surprisingly meaty, and they impressed Citigroup analyst Brent Thill, one of Wall Street’s sharpest software analysts. Changes include a four-fold increase in the index to 20 billion items, and improvements relevant to query refinement and query intent. The later is very important because (to use Thill’s example) what’s more frustrating to a user looking to finding information on the NBC’s “The Office” and getting a zillion references to Microsoft Office?

It’s about time Live Search improved, of course. In June, Google nabbed 45 percent of all search engine queries in the U.S., while Yahoo got 29 percent and Microsoft 13 percent, according to comScore Networks Inc. This represents a market share reduction for Microsoft of almost 3 percentage points from June 2005.

The aQuantive buy netted Microsoft three business units, including an advertising inventory marketplace, tools for measuring and improving the return on online ads and advertising agency. Suddenly Microsoft has a set of well-rounded offerings and a chance to develop strong ties with major players in the advertising industry. Another well-regarded software analyst, Charles Di Bona of Sanford Bernstein, called the acquisition “a solid fit” and set his price target for the stock at $37 a share, compared to the $29 price we’ve been seeing lately.

Platform company or content provider?

Having said that, Microsoft still shows signs that it isn’t altogether clear on how to transform itself. Matt Rosoff, an analyst with Directions on Microsoft, points out that the software giant isn’t sure if it is a platform company or a content provider. Platform companies in the advertising business serve ads to whomever pays, and that includes Google. Content providers have a very different business model. So Rosoff says he’s a bit puzzled by the acquisition of Jellyfish, a fairly small company that offers users a rebate when they its comparative shopping engine to buy stuff online.

Here’s the real news: No matter what you hear, Google and Microsoft are not in a death match. Google is a search company, and a great one, to be sure. It is slowly moving to bring services to users that compete with Microsoft’s traditional offerings. But its offerings aren’t even close (and won’t be for some time) in scope or quality to Microsoft’s core products.

And Microsoft, a great software company, is moving onto Google’s turf. But it’s obviously far behind, and will remain so for quite a while.

Investors understand that this is not a zero sum game. Successful companies don’t need to destroy their competitors. They simply need to make money. And both of them do — truckloads of it. So forget all that fashionable nattering about The Art of War, and focus on the bottom line.