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AOL's Choice of Google Leaves Microsoft as the Outsider
New York Times
By SAUL HANSELL, December 19, 2005

This time, it was Microsoft that was snubbed at the last minute.

In 1996, America Online agreed to offer Netscape's Internet browser to its five million customers. A day later, the nonbinding agreement was shunted aside when AOL announced that it had instead chosen Microsoft's Internet Explorer browser in a $100 million deal.

As recently as two weeks ago, Microsoft executives said they believed that their company was going to win the endorsement of Time Warner, AOL's parent, to form an advertising venture with AOL and become its provider of Web search technology.

But tomorrow Time Warner is expected to announce that it will instead renew its three-year-old partnership with Google as the provider of search technology. The deal, in which Google will invest $1 billion for a 5 percent stake in AOL, will also significantly expand AOL's advertising opportunities on Google sites, among other things.

The turn of events shows just how much Google - hotter now than Netscape was nine years ago - has supplanted Microsoft as the force to be reckoned with in technology. And it raises questions about Microsoft's stated goal of becoming the leader in Internet searching, as well as about its emerging plans to offer more online services under a new brand, Windows Live.

"I thought Microsoft would pay just about anything to get this," said David B. Yoffie, a professor at Harvard Business School. For Microsoft, he said, "AOL was the single best way to gain market share."

Yet Google found a way to trump Microsoft's hoard of cash, in part because losing to Microsoft was a strategic risk. Mr. Yoffie characterized the deal as "crucial and purely defensive" for Google because it "prevents Microsoft from being credible in search."

For years, Microsoft and its chairman, Bill Gates, won business from AOL and many others with money, power, technology and a presumed dominance of technical standards. For many Internet companies, it appeared to be the safest partner (despite continuing regulatory scrutiny of its business practices), much as I.B.M. was considered the surest bet for computers and information technology by a generation of corporate managers.

But for Time Warner, it was Google that appeared to be the safe choice in uncertain times. Google's search technology has been the leader in innovation, its advertising network has been a volcano of cash for AOL, and its brand is the hottest of all Internet companies.

Moreover, under this deal AOL will get assistance from Google that it did not have before. Google will help AOL in sending traffic to AOL's free, advertising-supported Web sites. It will also give AOL the ability to offer its existing advertisers search ads for the first time and will allow AOL's sales force to sell display advertising on Google's extensive network.

Microsoft - despite its many advantages, including promoting MSN services on Internet Explorer and on the Windows desktop - has not been able to become a clear leader in any online business. While MSN has strong global operations and some popular products, like its Hotmail e-mail service, it ranks third in reach in the United States behind Yahoo and AOL.

Like AOL, MSN's strategy has oscillated in recent years. For a time, MSN tried to compensate for a decline in its dial-up Internet access business with fee-based subscription services meant for broadband users, which proved unpopular. Then it pulled back from consumer marketing and diverted much of its resources away from MSN's advertising-supported Web portal to build an Internet search business meant to rival Google.

Meanwhile, Yahoo became a strong No. 2 in searching to Google by spending $2 billion to buy Inktomi, a Web search firm, and Overture Services, a Web advertising company. Microsoft's progress in searches and search-based ads has been slower because it is trying to build an entire business from scratch.

Now, Microsoft is building a second portal at Live.com and plans to introduce improved e-mail, instant messenger and other services under the Windows Live brand. At the same time, it is increasing its hiring to revive the MSN portal.

Even without paying much attention to the MSN portal, Microsoft was able to earn its first profit from the online unit in 2004 because of the booming market in online advertising.

In Microsoft's fiscal year ended in June, MSN had $2.3 billion in revenue, of which $1.4 billion was from advertising and $417 million came from operating income.

Still, Microsoft, despite its lagging position, had some appeal for Time Warner executives. Combining Aspects of AOL and MSN could have created a third online network with resources and users to rival Google and Yahoo.

For a while, there was a discussion of a complicated merger of AOL and MSN. But AOL decided that it could not split its advertising-supported portal away from its Internet-access business, which Microsoft did not want.

And Microsoft decided that it did not want to contribute its e-mail, messenger and, most important, its new Live.com portal to the venture. That left AOL worried that a new version of the joint venture would have to compete with online services owned exclusively by Microsoft.

After those talks broke off in mid-September, and Google reached out to try to win a renewal of its contract with AOL, Microsoft came back with a proposal to form a joint venture that would sell advertising on AOL, MSN and eventually other sites.

But AOL concluded that such a deal would make its reported revenue and profit decline, because that would require moving its profitable Advertising.com unit into a joint venture, with the income disappearing from Time Warner's books. This would have undermined the Time Warner objective of improving its stock price, particularly in light of continuing criticism by the investor Carl C. Icahn.

Moreover, a technical analysis by AOL engineers two weeks ago raised questions about Microsoft's advertising software and argued that the software that AOL had purchased from DoubleClick, the marketing software company, was better.

Now that Microsoft has lost the contest for AOL, it must find a way to regain traction on the Internet. Microsoft executives acknowledge that its search engine is not quite as good at producing relevant results as Google, but they promise innovations that will soon overtake its rival. The company is testing its Ad Center software for search advertising and hopes to replace Yahoo, which now sells MSN's search ads, this coming spring.

Microsoft's revival of MSN and its creation of Live.com are meant to allow users to choose among feeds of content from anywhere on the Web, like the service My Yahoo and the new Google home page.

A Microsoft spokesman, Adam Sohn, said, "Live.com is the set of services you use in your everyday life, and MSN becomes the place you go to get some content."

Microsoft is also counting on the link between a new version of its operating system, called Windows Vista, to be introduced next year, and the Windows Live Internet services to give it an advantage. For example, it plans to offer a search function that will not only search the Web and users' desktop computers, but their office networks as well.

Whether this connected search approach will enable Microsoft to dominate the Web as it has dominated the desktop with Windows, and browsers with Explorer, remains to be seen.

Steve Lohr contributed reporting for this article.

http://www.nytimes.com/2005/12/19/business/media/19aol.html