With Bill Gates preparing to retire next month, the Microsoft chairman gave his take on the future of the software maker’s online strategy – search advertising.

“You make these bets and you stick with them for more than five years,” Gates told an auditorium filled with Microsoft advertisers last week at the company’s Redmond, Wash., headquarters. “You bet on graphics interface, you bet on Internet browsing. Here with search, we believe that we can take it and embed it in a broader experience.”

But some observers say that Microsoft (MSFT) is gambling its future on the wrong type of online advertising. If Microsoft really wants to be a market leader, it should focus its efforts on display advertising.

“Display is a much more wide-open and fragmented market,” said Paul Levine, marketing vice president of AdBrite, a leading online ad network. “There’s an opportunity to be a real leader. The display market today is where search was five years ago. No one has a winning formula yet.”

Display is the preferred method of brand advertisers to broadcast messages through images and videos rather than text ads.

A Microsoft spokeswoman says the company is working equally hard on its display advertising efforts. The company has bulked up its display advertising presence in the past year with the purchase of marketing firm aQuantive and by signing partnerships with Viacom and social media sites Digg and Facebook. It also bought YaData, an Israeli startup that serves banners ads based on the way Internet users browse sites, and rolled out a new analytics service called “engagement mapping” to let advertisers know which of their online ads – display or search – are most effective.

Still, no one has yet found the way to dominate display advertising the way Google has done with search. Not even Google (GOOG) is there yet. “It’s fair to say that Google is not the leader in display ads,” Google CEO Eric Schmidt admitted to CNBC’s Maria Bartiromo in an interview last month.

Microsoft doesn’t hide the fact that it desperately wants to compete with Google in online advertising and that it bid $47.5 billion for Yahoo in an effort to catch up to the market leader. Google market share rose to 61.6% in April with Yahoo (YHOO) at 20.1% and Microsoft at 9.1%, according to comScore.

Though Microsoft CEO Steve Ballmer withdrew the offer to buy Yahoo earlier this month, he’s reconsidering a deal to acquire Yahoo’s search business.

Analysts don’t think that’s a good idea, either. “It makes more sense for Microsoft to work with Yahoo on display because it’s a much more open market and it will attract brand marketers,” said David Hallerman, an analyst with research firm eMarketer.

While Microsoft is pouring billions to catch up to Google in search, its competitor is investing billions to make its mark in the graphical display market.

Google’s acquisition of DoubleClick and YouTube are widely seen as ways to buy into the untapped market of delivering ads when people aren’t searching online. According to eMarketer, the U.S. search ad market is expected to double to $19 billion by 2012 while the display ad market, which also includes videos and rich media, is projected to triple to $18.7 billion.

With or without Yahoo, Microsoft is forging ahead with plans to chip away at Google’s dominance of search advertising. “A pure keyword search has its limits,” Gates said last week. “People want refinement. When a search doesn’t work, they want to know how they can go to that next step.” Gates said Microsoft will focus on delivering better results in specific search domains like commerce, travel, and images.

Microsoft’s first stab at taking search to the next level is through its “cashback” program, a rebate scheme that will pay Internet users money whenever they buy products like cameras and electronics through Microsoft’s Live Search engine. Microsoft is banking that as more people spend time buying on Live Search, more advertisers will promote their products, and Microsoft will grab a bigger slice of the paid search market.

AdBrite’s Levine, a former Yahoo exec, thinks that’s the wrong strategy. “People think of search on the Internet as a utility, like sticking a plug into a wall and getting electricity,” he said. “I have trouble believing that people will flock to different search engines for different purposes.”

Even if Microsoft is able to attracts enough consumers and marketers to worry Google, analysts say the cashback scheme isn’t a game changer. “In the unlikely event that Google experienced significant share loss to Microsoft as a result of Cashback, it would retaliate with a similar scheme of its own,” wrote Bernstein Research analyst Jeffrey Lindsay in a note to clients. “We see Live Cashback as more of a competitive discounting challenge than a truly disruptive new pricing model.”

Some argue that at least Microsoft should be applauded for finding an alternative to Google. “Big advertisers like eBay have a love-hate relationship with Google,” said Yen Lee, CEO of travel search engine Uptake and a former exec for Yahoo’s search business. “That Microsoft has a clever way of price-cutting, well that’s interesting to big advertisers.”