The sagging economy is only partly to blame. Much of the problems are of Microsoft’s own making. From a business point of view, for example, Vista was an unmitigated disaster. Enterprises have avoided it like the plague. A study by Forrester Research found that 86% of corporate PCs still run XP.

Then, of course, there’s Google, which owns the Internet search market, even though Microsoft has spent untold amounts of money trying to catch up. And Google has targeted the heart of the Microsoft empire by announcing that it is developing an operating system called Chrome and by pushing Google Apps as a lower-cost or free alternative to Microsoft Office.

Sounds grim, doesn’t it? The truth is, though, in the midst of all the bad news, it looks as if Microsoft has finally got its mojo back. There’s evidence that the company may finally be recovering from its worst year ever.

For a start, there’s the impending release of Windows 7. The new operating system is fast and responsive and has fixed many of Vista’s problems. It won’t be publicly available until late October, yet for a while it topped Amazon’s software best-seller list. It still hovers around 25th to 30th — impressive for software that won’t be available for months.

Microsoft also revamped its search engine, which it now calls Bing. Bing is an impressive piece of work, and for the first time Microsoft has a search site that can rival Google’s in terms of technology. And the company’s recently announced deal with Yahoo will help Microsoft gain more revenue from the Web.

Microsoft also released a very solid beta of Microsoft Office 2010, and Office will finally be available as a Web-based application. This will likely be enough to fend off Google Apps.

Finally, Microsoft put Apple on the defensive with a set of aggressive ads called Laptop Hunters that play up the price differential between Apple and Windows-based laptops. So what happened to Microsoft? Why is the company hitting its stride again?

The primary reason is cultural. Microsoft was always at its best when it believed it was an underdog. Bill Gates was excellent at creating that striver culture, but in his later years, one had the sense that his attention had wandered. And once he left, the company culture was adrift.

Microsoft’s culture has changed because for the first time in a long time, the company is, in fact, an underdog. Google has been on top of Internet search and services, Apple got all the buzz for its new products, and Vista was widely reviled.

Microsoft finally recognized that it couldn’t just sit on a pot of cash and giant market share. If it didn’t start releasing solid products and rethink its Internet strategy, Google could eventually own even the desktop. In short, the company got hungry again. That’s not to say that Microsoft is perfect. It needs to more aggressively Web-enable its applications, and it should slim down Windows and possibly release the operating system as a series of constantly upgraded mix-and-match components. It needs to develop breakthrough products in the way that Apple has done.

It’s hard to know whether that’s possible in the long run. But for now, at least, Microsoft has its mojo back.

In a long-awaited pairing aimed at taking on Google, Yahoo will handle ad sales while Microsoft gets the real prize: data on who’s doing what online

By Peter Burrows and Daniel Saltman

Ever since Microsoft (MSFT) made its $45 billion bid for Yahoo (YHOO) in early 2008, it was clear the software giant was serious about taking on arch-rival Google (GOOG) in the lucrative Internet search business. And now, after years of talks with Yahoo, it seems Microsoft has achieved its goal. In a 10-year deal announced in the early hours of July 29, Microsoft became the clear No. 2 in a market long dominated by arch-rival Google.

In a deal that presages its departure from a market it helped pioneer, Yahoo will scrap its own efforts to best Google in search and instead rely on Microsoft’s recently debuted Bing search engine. Ads placed next to those search results would be served up not by Yahoo’s ad platform, dubbed Panama, but by a Microsoft technology called AdCenter. Yahoo CEO Carol Bartz “is essentially giving up on search,” says Danny Sullivan, editor of Search Engine Land.

Yahoo salespeople will continue to sell search ads that appear on both Yahoo sites and on Bing, and Microsoft agreed to let Yahoo keep 88% of the revenue on ads that appear on Yahoo sites. But Microsoft will nevertheless reap a reward that’s more valuable in the long run. The data on computer users’ online search and buying habits would ultimately reside on Microsoft’s computers, thereby improving its ability to automatically serve up the most relevant ads. “If Microsoft is running the underlying ad technology, it doesn’t matter who is selling the ads,” Sullivan says. “In the end, Microsoft will hold all the cards.”

He adds that most advertisers place ads by filling out online forms, with no involvement from salespeople. Maintaining control of sales makes the deal “sound rosier for Yahoo than it really is, because in the end Yahoo won’t have the technology needed to compete.”

Insurance for Microsoft and Bing

Microsoft wins in other ways. The deal gives a big boost to Bing. The combined search market share of Yahoo and Microsoft would approach 30%. That’s still far below Google’s 65%, but analysts say it may provide enough of a critical mass at least to stave off further Google advances and help the enlarged search engine gain some ground. At a minimum, the deal doubles as a kind of insurance policy for Microsoft, in case all

of the positive buzz about the Bing search engine doesn’t translate into actual market share. By adding Yahoo’s 20% market share, Bing assures its place as the only search engine provider other than Google with size that really matters.

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So what’s in it for Bartz? For starters, Yahoo will slice $200 million in technology development costs, while continuing to bring in or even grow its search ad revenue. That’s because its salespeople will sell not only ads running on Yahoo sites, but also on Bing. Once it’s fully implemented, about two years after regulators sign off, the deal is expected to add an annual $500 million in operating income for Yahoo. The recently appointed CEO also buys time to hone Yahoo’s strategy and improve other moneymakers, such as placing banner-style display ads that appear on Yahoo’s highly trafficked portal and e-mail pages. And by continuing to sell search ads, she maintains relationships with key advertisers rather than let Microsoft walk away with them. “Yahoo doesn’t want to look like they’ve sold off their crown jewel for short-term gain,” Sullivan says. “This creates the illusion that they have more control of the situation than they probably do.”

It’s an illusion that will likely work with Yahoo’s long-suffering shareholders. Indeed, the deal will probably be welcomed by investors in both companies, since it lets each play to its respective strengths. Yahoo is most successful as a media company—and that includes selling advertising.

Microsoft, on the other hand, is a technology powerhouse, with vast software development capabilities and the cash to build the billion-dollar data centers needed to run search engines and ad platforms. The roles represent a stark reversal from half a decade ago, when Microsoft used both Yahoo’s search technology and its search-ad system. “It’s good for both of the companies,” says Sandeep Aggarwal, an analyst with Collins Stewart (CLST.L).

An Antitrust O.K. Is Needed

The arrangement will also have to get a nod from antitrust officials. It probably will, given both companies’ relatively small market share next to Google’s, and advertisers generally are likely to be in favor of the deal since it bolsters a competitor to the market leader. But Google no doubt will raise objections, which could at least slow down the approval of the deal.

Moreover, the complexity of the deal means it will take the two companies longer to integrate operations than if Yahoo simply outsourced search and search ads to Microsoft, as Microsoft originally proposed. “It’s certainly a deal with a bunch of moving pieces,” says Tim Cadogan, CEO of the online ad technology and services firm OpenX and a former Yahoo ad sales and search executive.

But if and when those pieces fall into place, it will become abundantly clear which party gained the upper hand in the arrangement, and which one has a fighting chance against Google.