As part of a strategy to earn more revenue from online advertising, Microsoft is testing display advertisements on MSN Spaces and several of its next-generation "Live" services, which are currently in beta testing. The company has also expanded its adCenter paid search platform to new advertisers in the United States. The gradual expansion of Microsoft's online advertising programs could impact other Web companies, particularly Yahoo, which provides most of MSN's paid search results today, and Google, which relies on Internet advertising for nearly all its revenue.

AdCenter in Transition

Paid search, in which advertisers bid for placement in search results, is one of the fastest-growing online businesses. However, MSN's paid search revenue declined between the Dec. 2004 and Dec. 2005 quarters. In contrast, market leader Google saw revenue from advertising on its sites—most of which is paid search revenue—grow 104%. Yahoo does not break out results in the same way, but its total advertising revenue grew 39% to US$1.32 billion in the same period; MSN's total advertising revenue grew only 12% to approximately US$330 million.

Microsoft blames the relatively poor results on the transition to its paid search platform, adCenter. Until fall 2005, MSN outsourced all paid search to Overture (a division of Yahoo). However, as MSN Search slowly replaces Overture with adCenter, MSN's revenue-per-search has decreased. Microsoft did not cite a reason for this decrease, but the most likely reason is that adCenter has launched in only two countries, France and Singapore, and is still a pilot program in the rest of the world, and therefore has a significantly smaller base of advertisers than Overture. Because keyword prices are determined by a continuous auction, fewer advertisers means less competition, resulting in lower keyword prices.

In other words, Microsoft has not yet signed up enough adCenter advertisers to make up for the revenue it's losing as its Overture deal ends. Microsoft expects this trend to continue for some time, as it warned in its financial filing for Q2'06 (the quarter ending Dec. 31, 2005): "We expect our overall advertising growth to continue to be tempered by the launch and ramp-up of MSN adCenter and the related pressure on our search advertising prices."

To mitigate this situation, Microsoft is trying to sign up adCenter advertisers as quickly as the new platform can handle them. Since the beginning of 2006, Microsoft has been expanding the U.S. pilot program with invitations to search-engine marketing companies. On Mar. 6, Microsoft opened the program up to all advertisers for one day, and it expects to offer other limited sign-up periods in the next several months as adCenter's scalability increases. As of the end of Mar. 2006, approximately 40% of the paid search results on MSN Search in the United States are being delivered by adCenter rather than Overture. The transition from Overture to adCenter will be complete by the end of 2006.

Expanding Display Inventory

During the adCenter transition, display advertising, such as banners and full-page interstitial advertisements (which interrupt the display of a requested page for a few seconds, then disappear completely), is a critical source of revenue for MSN. For example, Q2'06, display advertising revenue increased 20% from the previous year, even as search advertising revenue decreased.

With this in mind, in Mar. 2006 Microsoft began testing display advertisements on two services that are still in beta testing: Windows Live Mail (the successor to Hotmail) and Office Live. By starting these tests now, Microsoft can earn revenue even during the beta period and will be ready to ramp up advertising sales around the world when the services launch later in 2006.

In addition, Microsoft began testing display advertisements on users' blogs on MSN Spaces.

Next Steps

Eventually, Microsoft believes that unique adCenter features, such as the ability to suggest additional keywords for advertisers to bid on, based on query logs (e.g., people who search for "fishing lures" also often search for "Rebel," a particular brand of lures), will draw advertisers and search engine marketers away from Google and Overture, or at least convince them to split their advertising budget among three players instead of two. So, even though Microsoft's paid search revenue might continue to trail behind the rest of the industry in 2006, the continuing rollout of adCenter could place pressure on the competition. In particular, Yahoo expects the end of the MSN-Overture deal to cost it more than US$100 million in lost revenue in 2006. Although Google has no reliance on MSN, it is less diverse than Yahoo, with no display advertising or subscription business, making it vulnerable to market changes in paid search.

Microsoft says that paid search is only the beginning of a major push into online advertising, and although it has not yet disclosed details about its future plans, the following moves are likely:

• A future revision of adCenter will probably expand Microsoft's online advertising offerings beyond paid search and display advertising by enabling advertisers to place contextual, text-based advertisements across Windows Live and Office Live services (similar to the way Google displays contextual advertising next to e-mail messages on its Gmail site and on third-party sites through its AdSense service)
• MSN's sales force will probably begin to sell display advertisements across many Microsoft properties, including Windows Live, Office Live, Xbox Live, and the remaining MSN.com properties
• Following the lead of Windows Live Mail Desktop Search, Microsoft might develop other advertising-supported desktop software.

AdCenter is discussed in more detail in "MSN Brings Paid Search In-House" on page 23 of the Apr. 2005 Update.

Windows Live Mail Desktop is detailed in "Desktop Client for Windows Live Mail" on page 24 of the Apr. 2006 Update.