Ad Sales Seen as Key to Microsoft Internet Software Plan

The success of Microsoft's (Nasdaq: MSFT) decision to embrace the software-as-online-service approach, hailed by many as a landmark shift, may hinge on the software company's ability to make the platform work for advertising as well as for distributing software.

Analysts say the move to offer online versions of its software may well merge soon with Microsoft's development of its AdCenter technology for soliciting, placing and personalizing advertising. AdCenter, meant to rival and surpass similar offerings from Google (Nasdaq: GOOG) and Yahoo (Nasdaq: YHOO), is now in beta form in some key overseas markets.

Trying to Be the Standard

And because of the way people use software, Microsoft may be able to capitalize on a strong, ongoing relationship with its customers to build an online advertising business that, thanks to targeting and personalization, could become the industry standard.

Microsoft intends to move into the online software services field first with version of two of its most popular programs -- Windows Live and Office Live.

But executives have made it clear that is just the beginning of a more fundamental shift in how Microsoft approaches its business.

A widely circulated internal memo from Chairman and Chief Software Architect Bill Gates and Ray Ozzie, a software pioneer now working with Microsoft as chief technology officer after his P2P development firm, Groove Networks, was purchased by the software giant, emphasized the importance of building a long-term strategy around the Web as a distribution tool for software.

"The next sea change is upon us," Gates wrote in that memo, saying Microsoft had to "recognize this change as an opportunity to take our offerings to the next level."

More Than Just Google Answer

Analysts widely agree that while providing services online is a response to Google's sharp rise in the Internet world and it's recent dabbling in the software industry -- as evidenced by a recent partnership with Sun Microsystems (Nasdaq: JAVA) -- it is also a more significant strategic shift.

Forrester analyst Charlene Li said ad-supported software for consumers and very small businesses is "only the beginning" of a robust online service platform that developers will flock to.

"Microsoft's real aim is to build and host a service platform that will attract the investment of developers looking for a way to reach these market sectors," she said. "It is also a foray into offering its traditional client/server software to customers on a hosted or on-demand basis."

Some analysts have begun to express concern that Microsoft will move too far away from its traditional business model of selling packaged software, which has proven highly profitable even as Microsoft's growth has slowed. But Li said cannibalization of Microsoft's core revenue source seems unlikely in the short term.

Instead, Microsoft will likely be able to develop "new advertising and subscription revenues" though Li said the strategy will need to be carried out carefully to work, especially because Windows Live and Office Live ask consumers to trust Microsoft with much of their workaday lives, from calendars to contacts to important documents.

Resistance Seen

Some analysts say Microsoft could gain substantially in the online advertising segment if it can do for display and video advertising what Google has done with paid search and other forms of text advertising -- target messages at those who are most likely to be willing to hear or see them.

How far Microsoft can take that will depend not only on whether it can convince users to adopt the Live approach to software-as-service but also to how far it can take its AdCenter improvements, which are now being tested in markets such as Singapore and should be ready for U.S. debut by early next year.

Gartner (NYSE: IT) analyst David Mitchell Smith said Microsoft is clearly recognizing the competitive threat of Google and Yahoo with its Live offerings, but is also setting up an environment where it can derive ad revenues and "accustom users to paying a monthly fee to Microsoft for services." That won't be easy, he noted.

"Microsoft will face the challenge of evolving its business model to one that uses advertising, subscriptions and transaction fees, as well as licensing, in various ways for different products and constituencies," Smith said.

And there may be early resistance, especially in the business community. "Most IT organizations are wary of accepting software automatically downloaded from the Internet or using advertising-supported software," Smith added. Over time, however, the growing importance of the Web will mean that online services "eventually affect all enterprises."