MSN
2003 Financial Analyst Meeting
July 24, 2003

ANNOUNCER: Ladies and gentlemen, please welcome Vice President of MSN®, Yusuf Mehdi.

YUSUF MEHDI: Hi. Good afternoon. I think Xbox® is going to have a hot Christmas by the look of that.

I'm going to try and reset your thinking a little bit and now as we focus on MSN and the first thing I want to do is talk to you a little bit about just what is again MSN and what we're doing.

MSN is in the business of connecting people to other people and to the information they care about the most. And we are trying to fit into the notion of realizing people's potential by providing the software and the tools that enable that to happen.

When you think about MSN, there's really two businesses that we think about in terms of what we're doing here with MSN. The first is around communication and all things about helping people communicate with other people in terms of richness of editing. Bill demonstrated this morning the Outlook® Connector with MSN and how you can do that, things like anti-spam, instant messaging, the sets of services that really work great for individuals.

The other business we're in is in the business of information services. You could think of this as the ability for people to go out and search on the Web, be able to buy products, find marketplaces, get educated about information, news, weather, et cetera in a very personalized way.

And we do that with a couple of things that I think will differentiate us. Number one is a big focus on software that will help make the Web experience better. The second is personalization and the way we pull it all together. And then as you see below just a couple other things, being able to do a good job across the end experience, between how the user uses the computer and Windows® all the way out to how they use services on the Internet. We're going to do a really nice job of integrating that together.

Now, that is a very decidedly consumer-centric point of view, and that's been our focus but when you really do a good analysis of it, the ability to take these things, sets of services to small businesses and personal businesses is actually very straightforward and something that we're going to look at over time.

Now, rather than talking to you about it here I wanted to show you a short video of exactly how our software and services impact people's lives and really partly what gets us excited about coming to work and what we think our customer value proposition is, so let me just show you a little bit of the video from some real customers of how they use MSN.

(Video segment.)

So this gives you a great picture of just how people are using our software and services to stay connected.

So that's what we're about. So how have we done over the last year? Let me start first with my assessment of what happened in the industry from last year, and we can talk to you a little bit about MSN.

In terms of what's going on in the market, the online advertising market is clicking, pun intended, in the sense that we're doing fantastic as an industry in terms of driving new revenues, getting industry standardization, and in the paid-click model, paid services is really fueling a lot of growth. It's growing anywhere, depending on who you ask, somewhere between 30 to 40 percent year over year. So that has been going fantastic and really rising up.

The broadband revolution is certainly underway. In the U.S. this last holiday, we saw it with our access service. We saw how hard cable companies and telco companies have come out with low-price offers to really drive the market, and there are somewhere north of 80 million people in the world now on broadband.

And then this year was really the first year that we saw consumer subscriptions hit the market, so nothing that I would say was spectacular or amazing, but the most important thing is that a lot of companies now are trying to prove to consumers that you can pay for things on the Web; everything doesn't have to be free. And there have been first entries and I would say minor successes, and we've had one of those minor successes in that area.

And then finally, communications is still a primary thing on the Web. In fact, roughly 70 percent of all the minutes online still get spent doing e-mail and instant messaging. In spite of all the content and all the news and information you can read out there, the bulk of the time is spend communicating.

And one last thing that was really interesting is that in this last year consumer dissatisfaction on the Internet really did rise to a new level because of basically three major problems. In our research people called these things the three Internet devils is what they say: spam, intrusive advertising like pop-ups, and viruses. These three things have gotten to the point now where people are actually making decisions on whether to use the Web at all or whether to use one service over another. It's become that important.

I'll just talk about spam for a quick second. It's basically now roughly 48 percent of all e-mail out there that's going around in inboxes is spam-related mail. It costs only about a penny to send it, and it costs about a dollar to receive it when you do all the math of the time it takes people to delete it and get it off the servers and the like. So it's a very expensive problem; it's probably a $10 billion a year problem for the industry, and for consumers it's a major problem.

Hotmail® alone today will get 2.4 billion spam messages filtered out; these are the ones we'll catch at the server, so that just shows you how big a problem it is.

And spam is up from roughly 8 percent of e-mail in 2001 to 47 percent in this year, so you see how big a year it has been.

How have we done in the context of that environment? We have had really a pretty fantastic year in terms of revenue and contribution margin improvement. It's been basically a broad-based growth. We've done fantastic on advertising revenues both on paid search and on brand advertising, and I'll talk a little bit more about that. And on the profit-margin improvement, we've improved roughly I think 47 percent year over year the profit improvement on MSN, really just outstanding progress as a business in the progress towards profitability.

We've continued to be the most popular destination on the Internet. Over 300 million people come once a month to some property on the Internet, and I'll talk a little bit more about exactly what kind of assets we've built there.

The consumer subscription business evolves. That's basically shorthand for saying that in the last year I think last year when I was here I demonstrated how we were going to build a better service than AOL 8 and we've built that and technical review has written that, that we do have a better product and we took some share, but in that time period narrowband access basically has declined as an interesting place in the market segment and broadband has taken off. And our approach for broadband has changed, so what you see now is less of a focus about going direct with our own access service, although we'll continue that, and more a focus going with partnership companies like Verizon to bring broadband-based services to market. So the rise of nonaccess-based subscriptions this year has been a big thing for us in MSN, and it's certainly the focus of what we're doing as we go forward.

And then frankly an up-tick in customer satisfaction. This was a big focus for us last year because it drives a lot of our business fundamentals and it's the right thing to do for customers. And we did an up-tick across the board in all metrics, but I would say we still have room to improve.

And finally great execution with distribution and media partnerships, and again companies like Verizon, Verizon Wireless, Charter, Qwest, we've done some great performance there, and I'll talk about some of the content in partnerships.

In terms of advertising let me talk about online advertising, because that was a big drive of net new revenue in this period. Here are some numbers. These are my numbers, these are Microsoft internal numbers. You guys probably have better, more accurate numbers, but this is just a point of comparison. There in the first column you see fiscal year '02 performance on the online advertising segment, you have a total ad market of $400-plus billion. The online segment is roughly $7 billion.

Now, in last fiscal year '02 we actually did $561 million and had roughly 7.9 percent share of that market.

AOL was at a whopping $2.1 billion. I never thought we'd actually see the day when we'd actually catch up to those guys. And they had 30 percent of the market.

And then you see Yahoo! at $567 million when they had basically restated.

And then year over year they have basically performed as follows: You can see Yahoo has grown really nicely to $771 million, and they now have 11 percent of the share, and AOL really dropped fantastically, over a billion dollars of online ad revenue in the last year, a lot of that from these deals that they had signed in the Internet days that are going away, and I think some of that continues, they still have a couple hundred million dollars continuing.

And we had in that period, if I can say so, pretty fantastic growth. In fact, we've grown to $832 million for our online advertising business. We've passed Yahoo. And I think I would have no credibility to you if I stood up and said we were going to do that and the fact that we were able to do that this year is a good feat to the team that helped build that service.

And in the fourth quarter alone we beat both AOL and Yahoo this last fourth quarter on advertising performance based on what they've published and what we've done. We've actually done a greater amount. And you can see here just graphically how we've done, how we've grown the business.

So not only has the online ad market grown strongly, it's just a hot area to be in. We've actually done better than our share and taken share in a growing market, so it's fun. On the revenue side on advertising, we've done really a nice job.

How have we done with consumers, with people in the home? There, as I said, we continue to grow. In fact, now it's up to 350 million—I quoted you 300 million—350 million people who come once a month.

In the U.S. now we really do have a top media property. It's more than just reach now. Even on a dollar basis we are one of the top properties on the Internet in terms of being a media business.

You talk about basically roughly more people will look at our home page on a given day than will read the top seven U.S. newspapers combined.

On Hotmail, we continue as the largest independent mail. In fact, the quality of that base has gotten better. It used to be only 10 percent of the people claimed it was their primary mail. Today 66 percent of the people say it's their primary consumer mail for people who have a work mail and a consumer mail.

So we've really increased the value of that asset, which is Hotmail. And some fun facts behind it: If you ranked it in terms of total size it would be the ninth largest country in the world, behind Bangladesh and before Mexico in terms of population size.

Likewise with Messenger, another pretty amazing feat, roughly four and a half years ago we didn't have Messenger. Today we now have the largest free instant messaging service on the planet, and it's a pretty amazing feat. Nine million people are online simultaneously at any given time. And again some fun facts: That would rank as the ninth largest city in the world. I think it's behind Shanghai and in front of Istanbul.

And then in terms of search we have some good numbers in search, but I'll be honest, search has been an area where we haven't done a lot in terms of progress, mostly because we weren't investing in the technology to build a better search service, although a lot of people use it. I know a lot of you probably use other services and have a good experience, and that's one of the things we're going to focus on as we move forward.

And finally, we've done a nice job with subscribers, as I talked to you about.

How are we doing on advertising? The online advertising segment, why have we done the growth, why did we have the success we had last year in terms of online advertising? A couple reasons: Number one, we've done a good job with the big brands on the network. We've brought basically 90 of the top 100 brands now advertised online, and we've done special services for those folks that bring packages, people like Coca Cola and Lexus.

We have become an industry leader now along with Yahoo and CNET to set standards. In the same way that when you watch TV there's a standard ad type for the 30-second spot, 60-second spot, et cetera, we're now collaborating as a group to set standards for online advertising. I think that's going to fuel growth for everybody.

And we've done a bunch of studies to prove how spending money online will actually drive brand awareness, not just clicks but brand awareness better than if you took all that money and spent it completely on TV. And it's amazing how many companies yet have come around to embrace that. But as they do it, they see the results and it drives their business.

We're at the point now where I can actually talk to you about—if we got into the details—anyway I can talk to you about the CPM that is online, the E-CPM, the fact that we're actually driving up CPMs so we can see that growing and we can manage the business that way. So it's a confidence-inducing thing that we can now run our business in a very tight way.

On partners, we continue to do well. I quoted you some partnerships on distribution. On content as well, we've done fantastic. So ESPN is our sports channel. We've grown them by more than 70 percent. And Monster.com, which provides jobs, has grown by more than 50 percent. So we are a great place for driving traffic.

So what are the challenges for our business? What are the things that we look at in terms of going forward?

Number one, we still have a big challenge to continue to improve customer satisfaction and decrease churn. So I talked to you about the problems on the Web of spam and viruses and pop-ups. These are things that frankly affect all players, ourselves included, especially as one of the largest ones.

And then churn on subscriptions, certainly on narrowband access it's a big concern for us. But even as you move to nonaccess subscription, it will be a thing that we have to keep an eye on and improve upon.

In terms of building premium services, this is still something that is a challenge. We're just trying to convince people on the Web that you can pay for value, and we're starting to do that but doing that globally and in an easy-to-understand way for a lot of people—takes some time and we're building up that expertise.

Profitable customer acquisitions: That's been a challenge. We've actually done a better job over the last year now because we have better products, but we had to effectively pay a lot of money to go and acquire a customer and that affected a lot of our profitability. Now we're at a point where we're actually acquiring people on a profitable basis, but we still need to do a better job here if we want to drive big profits in this business.

I talked about the challenge of moving to broadband and how that's affected our ISP.

And then winning international markets: We have all the fantastic user-reaching growth; I quoted you all the numbers of people who use the service. If we're not able to basically sell advertising or sell premium services, it's going to be tough for us to cover those costs, so just continue to do a better job to win in international markets. We have the most popular service, so for us winning is really turning that into a profitable business.

And then finally in spite of all the fantastic progress I talked to you about online advertising, we still aren't at a point where even the basics for direct marketing and some big-time brand advertising happen. I talk to a lot of major accounts and they come in and they tell me, you know, "Yusuf, you've got five things you've got to get done before we'll even think of you as a direct marketer. If you can get those five things done then we can start talking about real money spent online." And that's with all the progress we've made already, so it just shows you how much opportunity there is.

It's a well-understood problem. We're working on it. I think within a year we'll actually have an answer for all those companies who want to do really high-end things. These are things that credit card companies and telco companies want to do. We'll be able to do those things in that level of depth.

Next is cost of operations, and so in the last year David Cole helped hire Debra Chrapaty, who is a former CIO, CTO for E*TRADE. She brings a wealth of experience for us in terms of running a high-scale operations business, and she is now helping us run our overall operations. And what we've already seen in terms of cost containment has been fantastic, and this is going to be a big thing for us as well.

And so finally, what are our priorities for fiscal year '04? What is it that we're going to go out and try and do to improve the business?

Certainly, we're going to continue to focus on customer satisfaction and partner satisfaction. So you'll see a lot of effort in what we do in product support, in terms of quality of service, in terms of the types of features we put into products to really get people satisfied and excited about what we're doing.

We're going to shoot to become the number one place to advertise online, so I would like to be able to come back here a year from now and talk to you about the fact that we do have the largest online advertising business in a year, that people think of us as the number one place to come and advertise online.

And we're going to do a bunch of things in that area around doing a better set of advertising of services for targeting, so that we can do things like we do in traditional media as well as a better job with some of the publishing platforms for how we publish the sites.

We're going to continue to deliver customer value through software so there will be a long list of things that we're going to do to improve it. I'll give you a short demonstration here in a second that shows some of the things that are coming, but we're going to do a bunch of investments.

Search is one big thing that we're doing. You already know that we're doing a big investment in algorithmic search to build what we hope will be the best way for people to go and find content.

People might say, well, gosh, I think someone has got a lock on that market, but when we go do the research with people, one out of every two search queries don't answer the problem that the people are looking for, and by our count roughly only about 30 to 40 percent of everything that's out there that's searchable actually is currently indexed by even the best search provider.

So although the early days have been good, we think there's a huge market there that's still unserved, so we're going to see a lot of investment from us in the search category to do a great job in the algorithmic, as they call it, the thing that helps you find what you're looking for, as well as in the paid search model with partnerships and if we have to on our own we're going to do that work there.

You'll see a lot of advancement in entertainment. So we've done really well in areas like financial, auto, retail. Entertainment is one where we've done okay but not as well. You'll see a lot of consumer services and a lot of advertisement services in the entertainment area.

My MSN, I'm going to give you kind of sneak peek of what we're going to do there. I bet a lot of you don't have it as your primary personalized home page. I predict by this fall you'll be thinking about using it as your primary home page based on what we're going to put out there for you.

And then some broadband services.

On the communication side, Bill demonstrated one thing we're really excited about, which is the Outlook Connector, the ability for you to share your calendar with your spouse or friends from work, with people who are on the Internet on Hotmail at an Internet café in Rio or in any number of other places; that cross-consumer work-sharing scenario we're going to do a really good job of making that happen.

A lot of work on spam, on anti-spam technologies, on instant messaging, which I'll show you in a second, and just more sharing of information.

We're going to do a big effort to continually reduce fixed costs. That's the only thing, frankly, that's left at this point for us to make major progress on is just reducing the fixed costs out of our current business and then just scale it so it continues to grow outside and grow internationally on a subscription basis.

And we're going to launch our first true global software subscription service that's access-independent. So we took a shot at it last year with MSN 8, but honestly that was an MSN Internet access product that competed with AOL. What I'm talking about here is a product that we're going to go out and tell people who run broadband, you can pay for your broadband service and if you wanted to pay extra we'll have a value proposition for you on why we can actually make that even a better experience and again I'll show you a couple things about what will go into that, but that will be a proposition we'll make. If we can hit on that, that will be a huge engine of growth and probably at least half the revenue of what we hope to do in this business will come through that type of subscription service.

And finally, we're focused on profitability, and as I said we made fantastic progress this last year. Profitability is completely in sight, and I think in the next couple years we'll certainly be there with MSN. And I'm more interested now in blowing through that than crossing that one milestone, so we have a lot of confidence about how we're going to do with the business there.

So it's really been a fantastic year, and I think next year for fiscal year '04 we're going to do really, really well as a business with MSN.

So I wanted to close by just showing you a couple things that are coming in MSN just to give you a flavor for what it's like in the product, and I'm going to ask Irving to come out and so he can show you five, 10 minutes of a few things coming out.

(Edited segment.)

...exciting year for us. Again, I think we're going to be a leader if not one of the leaders for advertising next year. I think with this wave of services that we'll have coming we'll really take some leadership and kick start the MSN subscription business, and I think next year will be really a great year for not just MSN but for the overall industry so we're happy about that.

Thank you.

END

Due to the varying sound quality and subject matter of tapes, the information in this transcript may contain inaccuracies.