Microsoft Must Kill Google, Now

There's a lot of chatter over Microsoft's (NASDAQ:MSFT) decision last week to fork over $240 million for a 1.6% stake in Facebook.

• "I'm not seeing how this makes any sense," argues MarketWatch's John Dvorak.
• The deal "demonstrates just how badly the world's largest software maker wanted to deepen its relationship with a start-up that doesn't even have $200 million in annual revenue," suggests Michael Liedtke of the Associated Press.
• And finally, as Fortune's Josh Quittner proclaims, if Facebook's revolutionary "social advertising" model takes off, "$15 billion for Facebook will look like the deal of the century."

I submitted my opinion last week: This isn't an investment, it's a cover charge. Microsoft doesn't really believe Facebook is worth $15 billion. But still, you'd be nuts to think that Microsoft would have paid up if there were no bonus schwag involved. In this case, it got expanded advertising rights on the popular social-networking site. That's what sealed the deal.

If we dig deeper, we can see that Microsoft's costly stake may prove to be a bargain if it succeeds in strengthening Microsoft while weakening Google (NASDAQ:GOOG). 

Killing Big G softy with its song
Microsoft -- and Yahoo! (NASDAQ:YHOO), for that matter -- can't afford to play it cheap. Google is too powerful in online advertising, and the competition isn't getting any closer. But now that all three companies have posted quarterly results, let's see how they stack up.

• Marketing revenues at Yahoo! inched 13% higher to $1.5 billion. What's troubling is that while ad money from Yahoo!'s own websites climbed 24% higher to $922 million, the company's fledgling collection of third-party sites that regurgitate Yahoo! ads posted a 1% decrease in revenues to $622 million.
• Microsoft's online-services revenues climbed to $671 million, but $80 million of that came from the aQuantive acquisition that closed during the period. Ad revenues would have climbed just 25% higher before factoring in that $6 billion deal. That's still respectable, although a major downer is that the company posted an operating loss of $264 million in this division.
• Google put up a whopping $4.2 billion in site-related revenues for the quarter, up 57% over the prior year. That impressive figure is the result of a 65% surge on its own sites to $2.7 billion and a 40% increase through its network third-party sites to $1.5 billion.

See the disparity? The non-Googles out there are huffing and puffing even as they continue to lose ground to the search leader. Yet how can the larger company be the one growing more quickly? However it's happening, one can sum up the current Microsoft and Yahoo! game plans to three simple words: Must Kill Google!

Affiliates, where art thou?
There isn't a lot that Microsoft and Yahoo! can do to make their own sites more popular. In fact, they're doing pretty well on that front.

That's a pretty tight race. Yahoo! leads the pack. Microsoft -- which runs both MSN and Live -- watches over two of the five most popular websites. So does Google. But why is Big G is so much better at monetizing its traffic?

Well, a lot of it is rooted in Google's strength in the search-engine space. Folks head to sites such as Yahoo! and MSN for free e-mail or news, and they stick around. Visitors come to Google, on the other hand, because they want to go somewhere else. Yes, it's true -- not being sticky can be a blessing in the lucrative realm of paid search.

Beyond that dynamic, we can also see that Google has been very successful in growing its network of third-party sites. Microsoft didn't break down how much of its ad revenue is coming from affiliated websites, but it's obviously a fraction of what Yahoo! is drumming up. And before you pat Yahoo! on the back, note that Google generates nearly three times the ad revenue from its AdSense network as Yahoo!'s YPN platform does.

Google's program is generous. In its latest quarter, Google paid out $1.12 billion of the $1.45 billion in ad revenue generated through its network -- or 77% -- right back to its publishers. It also costs a bit more to keep the program running: Google rang up traffic acquisition costs that totaled 84% of the related revenue.

So that's it? Microsoft or Yahoo! just has to offer up 77%? Of course not. It's more complicated than that. Think about the network effect for a moment. A company such as eBay (NASDAQ:EBAY) becomes practically untouchable because bidders want to go to where the sellers are, while sellers want to be where the buyers are.

A similar thing is happening in paid search. As I mentioned, Google generates nearly three times as much in ad revenue as Yahoo!, and it pulls in more than six times what Microsoft collects. For third-party publishers, those stats mean two very important things.

• A wider network of sponsors translates into healthier bidding on keywords.
• More sponsors means better ad targeting, and better targeting creates a greater likelihood of lead-generating ad click-throughs.

All three search heavies offer sweetheart deals to large publishers, but Google's competitive advantages make it an easy sell for everyone else. Whether it's News Corp.'s (NYSE:NWS) MySpace, Answers.com (NASDAQ:ANSW), or even a second-tier search provider such as MIVA (NASDAQ:MIVA), going with Google becomes an easy choice.

Microsoft and Yahoo! need to realize this. They will have to offer far more than 77% -- perhaps even more than 100% -- to matter. It had better happen soon, too, because the Google network effect is growing with every passing quarter.

But why would a market leader like Microsoft pay out so much? Well, it's a lot like a supermarket selling milk at a loss and stocking it in the back of the store, to make sure that guests pick up impulse items along the way. Even if Microsoft takes a margins hit, doing so could help slow down Google if it means broadening Microsoft's own pool of sponsors.

That makes sense, right? If you're going to kill Google, you have to do it sooner rather than later. So is Microsoft really overpaying for Facebook? Sure, $240 million is a lot to pay for a hit man, but it's a rounding error in the context of the real billions that are stake.

Some cool widgets for your Facebook profile:

• Facebook may be the next Mr. Softy.
• The Yahoo! overtures proved fruitless last year.
• Microsoft sneaked in as Facebook's contextual marketing provider.