Google vs. Microsoft

I wrote Tuesday about trouble with Google’s AdWords platform. I noted that it’s not performing as well as it used to, and that that will spell short-term trouble for the company and stock because 99% of Google’s revenue comes from its ads.

On Wednesday, Digg switched from partnering with Google to provide ads on its reader-powered news site, to partnering with Microsoft. Digg will still display small text ads, just like the ones previously delivered by Google, but now they’ll come from Microsoft and are expected to be better.

How could this be? Google is supposed to be the cutting edge of all things Internet, yet it’s grown relatively stodgy in the ad business, which is its only revenue-generating endeavor. Everything else it does is just to gather people around pages that show content and…ads. If it blows it in the ad game, it’s in real trouble because that its only game.

Meanwhile, old crusty Microsoft is leading the charge in the ad category. Jay Adelson, Digg’s CEO, said his company couldn’t “think of a better partner to get to where we need to go. They’re a young ad service, they’re innovative, they’re willing to work with us on the cutting edge.”

Last summer, Microsoft signed up the social networking site Facebook. Now it has Digg. It’s in the process of acquiring aQuantive to keep its adCenter division at, well, the center of advertising.

Rather than Google’s plain-Jane pasted-on-the-page ad system, Microsoft is developing a more interactive approach. Users have been screwed by too many worthless text ads that have, in fact, little to do with what they’re doing online. The context sensitive approach was nice five years ago, but has been worked to death to the point where fewer and fewer people bother looking at anything but organic search results (the ones that the web turns up by actually searching, not the ones that are placed as ads). Everybody’s onto the text ad trick by now.

Steve Berkowitz, a senior vice president in Microsoft’s online services group, says Microsoft is the innovator, not the copy-cat, in online advertising. “We actually now are in the forefront of what we believe is going to be the next generation of advertising.”

True, Microsoft has a long way to go to catch up with Google, but it certainly doesn’t lack the money to get there.

I’ve written for some time now that my interest in Google has to do with its endeavors to make Microsoft alternatives. I want to use Google Docs instead of Microsoft Office, for instance, and I’d like to see an entirely free operating system made available and amazing, just as Mozilla has made the entirely free Firefox the best thing in browsing. Try using Internet Explorer after Firefox and you can scarcely believe anybody’s stupid enough to keep it.

Is Microsoft taking Google’s encroachment onto its core turf in stride? No. The Redmond giant is well aware that its main business is threatened by web-based applications, online advertising, and other ventures.

Last night, Microsoft CEO Steve Ballmer told analysts that web services and consumer devices are vital parts of the company’s future. He said, “Great things don’t happen overnight. Most successes require long-term investment and innovation…and that’s our perspective.”

He said he sees more opportunities for growth in the next 10 years than in the past 30 years. Rather than hiding from new, disruptive technologies, Microsoft will embrace them. He referred specifically to the threat of web-based software versus Microsoft’s traditional local hard-drive-based software.

“Every piece of software — the basic core value in the way software gets created — will change in the next three, five or 10 years,” he said, and predicted that all software will soon use the desktop, Internet, and server to get its job done. He said that software will never switch to an Internet-only model.

What’s going on here?

Google is an online advertising company that has plans to become a software company. Microsoft is a software company that has plans to become an online advertising company. They’re both much better than the other in their current area of strength at the moment, but they’re both looking a little uninteresting in that area as the other catches up in exciting ways. They both have a lot of money to get where they want to be.

Microsoft shares were stuck between $22 and $30 from mid-2002 to mid-2006. From early June of last year to now, the shares are up some 36%, but that’s just the difference from $22 to $30, so the situation hasn’t changed all that much. Pay no attention to what excited onlookers say about the percentage gain.

Google shares are the toast of the town, having gone up 400% from $100 to $500 in the past five years. However, there’ve been bumps along the way. From January 2006 to mid-March 2006, GOOG dropped 28%. Could we be on the verge of another such sale?

I think so. It reported earlier this month that it hired 1,500 new people. It now has 14,000 people on its payroll to support all of its new endeavors, not one of which makes money beyond providing pages for ads. It’s little surprise, then, that Google’s operating margin has fallen from 35% two years ago to less than 29% now, and it’s still falling.

I’d steer clear of GOOG shares for a while. Keep using all of its amazing services, keep loving the pressure it’s putting on Microsoft to innovate, keep hoping that it announces one day an entirely free operating system, but let the sale around its shares continue.

This Weekend To Subscribers: How our watch list is getting closer to our target buy prices in this falling market, the profit potential of Japan, whether this is the right time to start a permanent portfolio at sale prices, and a look at the stock we purchased on Tuesday for a price much lower than what Morningstar suggested for this 5-Star stock.

Coming Soon On This Free Site: Good investment resources versus ones that just generate noise, Panera Bread versus Starbucks, Blockbuster versus Netflix, what’s wrong with U.S. health care, and more.

Disclosure: The Kelly Letter portfolio includes Microsoft, currently up 33% for us.

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