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Why can't Microsoft make money online?

Yes, the software giant is hugely profitable. Just not where it competes with Google.

By Adam Lashinsky, senior writer
Last Updated: November 26, 2008: 12:30 PM ET

(Fortune Magazine) -- Struggle? You don't normally think of that word applying to the company Bill Gates founded. But there it is: Microsoft, one of the most aggressively competitive, brainiac-attracting, technologically superior, and oh, yes, cash-gushingly profitable companies of all time, can't for the life of it make a dime on the Internet.

It's not as if earning money on the web is such a remarkable feat. Everyone knows that Google (GOOG, Fortune 500) remains the company of online advertising, generating operating profits of $1.7 billion last quarter on revenues of $5.5 billion. Yet even industry doormats Yahoo (YHOO, Fortune 500) and AOL are profitable.

Yahoo, so badly managed that co-founder Jerry Yang recently demoted himself from CEO to "Chief Yahoo," eked out operating earnings of $70 million in its most recent quarter. Yang's return to Chief Yahoo status (he'll keep his board seat) renews speculation that Microsoft will try again to buy Yahoo, or at the very least, ink a search deal with it.

But that's getting ahead of the story of why Microsoft (MSFT, Fortune 500) wanted Yahoo in the first place. AOL, a shell of its former self (and, like Fortune, a unit of Time Warner (TWX, Fortune 500)), earned $268 million in the same quarter.

As for Microsoft, which has been at this online thing for a decade, give or take, losses continue to mount. The division in question is Microsoft's Online Services Business, which includes the online portal MSN, the aQuantive ad agency Microsoft bought last year for $6 billion, and Live Search.

For the quarter that ended Sept. 30, online revenues grew 15%, to $770 million. But the unit lost nearly half a billion dollars ($480 million, to be exact). That loss was 80% greater than the year-earlier quarter's splat of red ink.

At one level, the explanation for Microsoft's weak showing is simple. Desperate to catch Google, Microsoft has been spending like mad on data centers, people, and marketing. But its online audience is relatively small - much smaller than Google's - and those costs grossly outweigh sales. (Some 72% of the online unit's revenues come from ads, most of which are of the display variety, as opposed to search ads.)

Microsoft may have been noodling on the web since the 1990s, but it was only four years ago that the company woke up to the need to compete in search - where a disproportionate share of online profits are today. Hence it is the new kid on that block, a tough place to be in a world where Google is as much the neighborhood bully as Microsoft is in PC software.

Microsoft is understandably touchy on the subject of its online travails. The company declined to provide any of the five executives who have direct responsibility for its online businesses - Windows chiefs Bill Veghte and Steven Sinofsky, former aQuantive CEO Brian McAndrews, search-engineering head Satya Nadella, or web-marketing honcho Yusuf Mehdi - for interviews.

A different Microsoft executive responded testily when approached at an industry event in San Francisco with the query that is the headline of this article. He argued that Microsoft is all that stands between Google and the destruction of ad-supported media as we know it.

"We're doing this for you," he snapped, jabbing his finger into the sternum of a startled Fortune writer.

Microsoft knows it has a problem. In May the former head of online, Kevin Johnson, told his employees in a widely circulated memo, "The fact is that we are not where we want to be in this business yet, and we've been in this position longer than we'd like." Johnson did find a way out of that position for himself: He left Microsoft in July to become CEO of Juniper Networks, a telecommunications-hardware company.

The next day Steve Ballmer, Microsoft's voluble CEO, used an anatomical analogy to explain the company's online shortcomings. "Our PC muscles are very well developed, and our server and enterprise muscles are very well developed," he told a group of financial analysts. "Our Internet muscles aren't yet as well developed. But we want to go after it with the same energy."

It's quite possible that Microsoft is going after the Internet with too much energy - or at least attacking in too many directions. Rather than carve out some element of the web where it can shine, Microsoft pursues everything.

Its Live Search competes head-on with Google. MSN and Hotmail do battle, unimpressively, with Yahoo's e-mail service and Google's smaller but innovative Gmail. With recent tweaks to its Windows Live product, Microsoft is mimicking Facebook, in which Microsoft itself invested. (Refresher: Last year Microsoft paid $240 million for a 1.6% share of Facebook.)

Yet even where Microsoft racks up the most revenues, in its MSN portal, it relies on partners like Fox Sports and MSNBC to do the heavy lifting in terms of creating content. That dilutes Microsoft's operating leverage as well as its creative control.

"They're trying to do everything every major online company does," says Salman Ullah, a venture capitalist who previously served stints as a dealmaker for both Google and Microsoft. "Yet they only monetize one way: brand advertising. And they share that revenue overwhelmingly with partners."

For a company that has long been known for the clarity of its message - the old mission statement, "A computer on every desk and in every home, running Microsoft software" - Microsoft isn't all that clear about what it wants online.

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