Microsoft eyes ads as consumers close wallets

Software giant gets only about $2 for each copy of Works on new PCs, and there is no money in Money, CNET News.com has learned.

Ina Fried Former Staff writer, CNET News
During her years at CNET News, Ina Fried changed beats several times, changed genders once, and covered both of the Pirates of Silicon Valley.
Ina Fried
6 min read
Although Office and Windows continue to produce vast revenue and profits for Microsoft, some of the company's other well-known consumer titles are generating only a trickle of business.

According to internal documents seen by CNET News.com, Microsoft gets only about $2 for each copy of Works that is bundled on new computers. The standard version of Money isn't even a break-even proposition, and the company has had to heavily discount its OneNote application in order to get computer makers to include it.

Microsoft predicts that things won't improve from here, either.

"The outlook for the packaged consumer retail software market is poor," MSN workers said in an internal strategy paper seen by CNET News.com. "The size of the market is shrinking, and consumers appear less willing than ever to buy software applications off the shelf."

In the paper, Microsoft said that worldwide sales of full packaged software--which includes Works, the Encarta encyclopedia, digital imaging software and Money--dropped by 7 percent in fiscal year 2004. In addition, the company said it was seeing similar trends for fiscal 2005.

The tepid forecast, combined with concerns that others might offer free versions anyway, is prompting Microsoft to take a hard look at selling free, ad-supported versions of many of its consumer titles, like Works. And, in some cases, the numbers may well add up.

Calculating that the average person keeps their copy of its entry-level productivity suite Works--a kind of "Office lite" for consumers--for about three years, Microsoft reasoned that it wouldn't take a lot of ad revenue to justify moving the product to an ad-driven model.

"That means that if ad revenues exceed 67 cents per year, we could actually give Works away and still make more money," two Microsoft researchers and one person from MSN stated in a paper presented to Chairman Bill Gates at a Thinkweek brainstorming session earlier this year.

Microsoft is not alone in seeing its consumer business trail overall software spending. IDC estimates that consumers worldwide spent $4 billion on software last year, and that total is pegged to reach $4.7 billion by 2009--a compound growth rate of just more than 3 percent.

By contrast, global packaged software revenue is much larger--$91 billion in 2004--and projected to grow to a healthy $120 billion by 2009.

Software revenue chart

Consumers just aren't seeing enough value in what's inside most software boxes, IDC analyst Albert Pang said. With programs like Excel and Word, Pang said, most people just use a fraction of the features and aren't willing to shell out big bucks.

"Only professionals are willing to pay the full retail price for the software," Pang said. "Somehow, somewhere, a better strategy needs to be developed to expand the market," Pang said.

Members not wanted
The MSN strategy paper argues that subscriptions are not the way to go, pointing to the success of Google's ad-supported Gmail. If Google's Web mail service is successful, Microsoft estimates the annual revenue per subscriber could top $20 per user, leaving "no room left at all for mass market consumer subscription services."

Instead, the paper points to nontargeted advertising as the way to go to pay for basic, low-cost services.

"High-cost services (many of which are currently paid) will be funded by an exchange of user information that will allow better targeted advertisements," the Microsoft paper contends.

The software giant has confirmed that both papers are genuine, but has declined to comment further. A Microsoft source noted that both papers represent internal brainstorming around new business models and that no decisions have been made.

In the MSN-drafted paper, Microsoft points to controversial adware maker Claria, noting that Claria claims ad rates six to 20 times those of traditional Web advertising because of its ability to target to a user's activity. Microsoft was said to be in talks to buy Claria earlier this year, though no deal was announced.

Microsoft has been building its own engine for targeted ads, known as AdCenter. The product, originally code-named Moonshot, combines context of what a user is searching for with demographic information about who is doing the searching. Initially, Microsoft is using AdCenter to serve up keyword-based search ads. However, the company has said its ambitions go much further.

"Today, it's keyword," Joanne Bradford, Microsoft's chief media revenue officer, said in an interview last week. "We believe in the future it will be about display (ads), video and all that is advertising."

Top Microsoft executives, such as Gates and Chief Technical Officer Ray Ozzie have also been calling for the company broadly to get more revenue from online advertising. Microsoft has already outlined two new ad-driven services: the consumer-oriented Windows Live and Office Live, which is aimed at small businesses.

Goldman Sachs analyst Rick Sherlund said Microsoft needs to consider a wide array of new models, including both advertising and subscriptions.

Candidates for freedom
Works, he agrees, is a good candidate to be offered for free and supported by ads. "They could deliver this as a service and get minimal ads and be money ahead," Sherlund said in an e-mail interview. "This would be market expanding."

Microsoft would likely see similar benefits if it offered Money, its personal finance software, as free and ad-funded, he said.

"I think (Microsoft) should not be afraid of offering most of their products in all three modes."
--Rick Sherlund, analyst, Goldman Sachs

But other software is better suited to being hosted on a server and offered up by subscription, Sherlund said. Still, other users, particularly business users, are likely to want software that they can run on their local PC, ad-free and without having to be connected to the Internet.

"I think (Microsoft) should not be afraid of offering most of their products in all three modes," said Sherlund, whose analyst firm has done banking work for Microsoft. "Better to cannibalize yourself and block competitors than have others step into the market unopposed."

The OneNote note-taking program represents an interesting example of, at the extreme, the types of products that could be funded by advertising. In one of the papers, Microsoft notes that it is trying to create a whole new category of software, something that is "not easy to do."

As a purely desktop application, it is maybe not in the first category of software likely to be thought of as suited for ad-based conversion. But, the Microsoft workers noted, it is also one of the Office application that users keep open longest (second only to Outlook e-amil).

"Since advertising revenue depends roughly on time used, this means OneNote has substantial potential," the paper posits. Plus, the authors noted: "OneNote's low sales to date?mean that so far, there's little risk of cannibalization."

But Pang isn't sure advertising is the answer. There are already so many Internet ads, that he thinks computer users will just get overloaded if their desktop software starts spitting out solicitations as well.

"I don't see how marketers will want to take that risk when there are so many more effective ways to reach end-users," Pang said.

Pang has a different idea. He suggests Microsoft and others should partner with service providers, who could underwrite some of the cost of software and integrate it into what they do. For example, your bank might bundle Microsoft Money with its own online account tools. Or perhaps Comcast Cable might pick up some of the cost of software for managing digital photos and bundle that product with its TV and Internet services.

There have been some examples of such pairings, as many Internet service providers have in antivirus software. That has a double benefit of adding to the perceived value of the subscription and helping to keep bugs out of their networks.

There have been other online examples. SBC Communications, for example, has its partnership with Yahoo, in which high-speed and dial-up subscribers get additional Yahoo features and services as part of their monthly fee.

"I see that type of bundling much more effective and palatable to the users," Pang said.