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Microsoft ready to spend--but on what?

Ad execs could get a hint of what the software maker will pick up in its planned spending spree. Images: MSN's AdCenter

SEATTLE--Just what does Microsoft plan to spend all those billions of dollars on?

That's the question that Wall Street has been asking since last week, when the company announced that it would pay out far more than expected in the next 15 months--roughly $2.4 billion according to estimates--as it bulks up several of its new business efforts, particularly its online services.

Investors may get some answers this week, as the Redmond, Wash., software maker hosts an annual gathering for hundreds of MSN advertisers and other ad industry notables. Microsoft is expected to give further details of its strategy and to show off some of the earliest fruits of its labors.

Much of Microsoft's focus--and spending--centers on online advertising as the company bulks up to better compete with Google and others. Its biggest bet in that area has been its decision to switch from Yahoo's ad-serving technology to its own homebrewed alternative, named AdCenter.

Over the long haul, the company hopes that AdCenter will prove more adept at targeting advertisements to the individual user, in the process sending more revenue its way. That was not the case in the past quarter, though.

That's when Microsoft shifted the majority of its U.S. search advertising over to the test version of AdCenter. However, revenue per search actually fell, as the company is still ironing out the kinks in the product and building its base of advertisers.

Credit Suisse estimates that Microsoft has moved from an ad network of 300,000 advertisers to one that, for now, stands at less than one-tenth that figure, according to a research note from the firm's analyst Jason Maynard.

"While we assume that the number of advertisers will climb substantially over the next 12 months, we are underwhelmed with the stickiness of the Microsoft Web properties," Maynard said in the research note last week.

Executives insist that the move is right for Microsoft in the long term, whatever growing pains it is feeling now.

Images: AdCenter stages

"Further growth of AdCenter is key," CEO Steve Ballmer wrote in a memo sent to employees after the company reported earnings last week. "Our goal is to create the Web's largest advertising network, giving us an engine that will enable us to monetize our services and compete against Google."

On the agenda
The software maker is expected to demonstrate an updated test version of AdCenter at this week's conference, with a final version targeted to be ready by June.

Also on tap should be a clearer explanation of where Microsoft is headed with MSN, its online property. Many of MSN's existing services, such as Messenger and Hotmail, are being re-fitted with the Windows Live banner. However, the company is pushing ahead with a dual-brand strategy. At the meeting, it is expected to make its case to advertisers as to why both outlets make sense for their marketing bucks.

And it's not just Web sites that Microsoft may be looking to fill with ads.

It's expected to announce this week that it has scooped up Massive, a company that serves up advertising to slots within video games.

On top of that, Microsoft is exploring whether it makes sense to use advertising to subsidize desktop software as well. Currently in testing is a product called Windows Live Mail Desktop, a free desktop e-mail reader. It's meant to augment the Windows Live Web-based e-mail service, a revamp of Hotmail, that the company has spent the last two years developing.

On the table is a much broader ad plan. Under this, the company would offer any number of software products, including well-known mainstays like Microsoft Works, for free to those willing to view ads along with their documents. It has yet to announce any plans for such an undertaking.

Follow the money
The question remains, just where are all those investment dollars going?

Some of it will be spent on hiring, Microsoft has said. It also expects to bulk up the physical infrastructure--such as server farms and networking gear--needed for its services push. In an interview with Fortune magazine, Chief Technical Officer Ray Ozzie said that the hardware investment needed will cost "staggering" amounts of money.

Not all the money is going into Windows Live and MSN, however. Microsoft plans a huge marketing campaign for the launch of Windows Vista and Office 2007. Both products are slated for a January launch, though some analysts see further delays on the horizon. The company is also boosting its Xbox shipments to try to move as many of the game consoles as possible before Sony's PlayStation 3 hits the market, and each Xbox is shipping at a loss.

Merrill Lynch did its own estimate of what an extra $2.4 billion in expenses could purchase. Analyst Kash Rangan said that it could buy 200,000 servers at a cost of around $500 million, hire 10,000 developers at a cost of $750 million to $1 billion, pay for $700 million in networking gear and still leave around $300 million to subsidize millions of Xbox 360s at a loss of $25 per console.

Regardless of where the money is going, Credit Suisse's Maynard said that "Microsoft is spending enough money to build a Google-sized business inside their company."

And that money may not be enough to catch up, he said in his research note.

"We are not ready to say that it is too late for Microsoft to improve its prospects, but we find it very hard to believe that the growth of pure-plays like Google, Salesforce.com and Yahoo will be impaired by desperate and reactive spending measures," Maynard said.

Ballmer, meanwhile, told Microsoft workers that the push is just the kind of big bet that has paid off for the company in the past.

"Now is not the time to scale back the scope of our ambition or the scale of our investment," Ballmer wrote.