Microsoft: Let's Make More Deals

With its increased emphasis on video content, the software giant is slowly refashioning itself as a media powerhouse

During the last few weeks, Microsoft (MSFT) has made several acquisitions to feed the ever-growing demand for content on MSN, its huge online network. On May 4, it announced the purchase of Massive Inc., a privately held New York company that places ads in online games, for an undisclosed amount. Last month, the company acquired British game developer Lionhead Studios, which will develop content for Microsoft's Xbox 360 game console.

The hunger for more online content will likely lead to more deal-making in Redmond. News reports last week said Microsoft has contemplated an acquisition of Yahoo (YHOO), MSN's larger rival online network. While no deal appears to be imminent, the reports underscore how Microsoft's evolving business model is putting more and more emphasis on content.


  Microsoft built its business selling shrink-wrapped boxes of software for desktop computers. Now it's shifting more of its focus to the Web, where rivals such as Google (GOOG) already distribute word-processing software and other tools that compete with Microsoft products. In many cases, these tools are available for free to users who view online ads.

In addition, Microsoft hopes to grab more of the fast-growing online advertising market by investing directly in content, from stories and video on MSN to online games played on the Xbox console.

Given that Microsoft has little experience in developing content beyond its core software business, it will have to look outside to fill its needs, either through partnerships or direct acquisitions. "And it will need more software and infrastructure to aid in the delivery of content over the Web," said analyst Joe Marchese of Bainbridge, a research firm in San Diego.


  The extent of the growing pains became obvious on May 4, when CEO Steve Ballmer met with a group of online advertisers at Microsoft headquarters in Redmond, Wash. He candidly admitted that their demand for ads was putting pressure on the company. "We're delighted with where we are in content. We're driving hard. We think people want that kind of an experience," Ballmer said during the meeting, which is known as the Strategic Accounts Summit.

But, he added, "Frankly, we're a little sold out right now on inventory. We think the desire for people to read online and the desire you have to communicate online actually exceeds the good inventory that's available out there today."

The need for more content is urgent (see BW, 5/15/06, "Mixed Signals from Microsoft"). Online advertising is growing fast, at 25% to 30% a year, according to Avenue A/Razorfish, an online agency owned by aQuantive (AQNT). Growth rates for traditional forms of advertising vary but average in the single digits. If Microsoft wants to take advantage of that growth, it needs to position itself now, while online advertising is still young and accounts for a relatively small percentage of ad budgets.


  Ballmer said Microsoft is "stepping up" its investment in content. On May 3, the company announced the formation of MSN Originals, which will feature the creation of original storytelling for MSN. The project includes a partnership with Reveille, the independent Hollywood production studio behind NBC's The Office and The Biggest Loser, FX's 30 Days, MTV's Date My Mom, and also with Be Jane, a multimedia content producer and Web community for women's home improvement.

What will Microsoft do next? After discussions with experts from Wall Street to Silicon Valley, here are five more ideas for partnerships and acquisitions that might make sense for Microsoft as it beefs up its content business.

Microsoft executives were bitterly disappointed in December when the company lost a bid to displace rival Google as the search engine on Time Warner's (TWX) AOL network. One Microsoft executive said the company was determined to land the deal, if for no other reason than because Google wanted it badly, too.


  But Google ended up signing a new deal with AOL , taking a 5% stake in AOL for $1 billion (see BW Online, 12/18/05, "Why Was Google So Desperate for AOL?").

"AOL has a lot of content, and they're exceptionally good at programming it, making it look good and interesting," says analyst Joe Wilcox of market-research firm Jupiter Research. The same can be said of the larger Time Warner empire. So it wouldn't be surprising to see Microsoft and Time Warner forge closer ties.

People close to the company say Microsoft execs have an increasingly good relationship with Time Warner CEO Dick Parsons, the AOL-Google deal notwithstanding. It might even make sense for Microsoft to use some of its huge cash pile to make an investment in Time Warner, just as it invested $1 billion in Comcast (CMCSA) back in 1997.


  Some analysts even believe it would make sense for Microsoft to buy Time Warner outright. "It would be a great move," says analyst Susan Kalla of Caris & Co. In such a deal, Microsoft would be able to take advantage of Time Warner's current low multiple, without hurting its own valuation or stock price, she adds.

And Microsoft has few options when it comes to buying a large media company. There's little to no chance of Microsoft doing a deal with Disney (DIS), now that Apple (AAPL) founder Steve Jobs has sold his Pixar Studio to the Mouse House and become a Disney board member. Long-time rivals Jobs and Microsoft Chairman Bill Gates would make reluctant partners, at best.

Such a deal is unlikely, though. While Microsoft needs more content, a takeover of that scale would be complex and treacherous. Microsoft has never made an acquisition anywhere close to the $73 billion market cap of Time Warner.


  Microsoft also would end up so deeply in content that it would be forced to manage a risky and volatile operation business where it has limited experience. And such a deal would include many things Microsoft may not want, such as cable-TV networks.

If Microsoft does buy content outright, it's likely to make a play at a much smaller level. It tends to prefer smaller acquisitions to blockbuster deals anyway, and that's probably more true in media than in businesses such as software, where its expertise lies. That's why it might make sense for Microsoft to take a look at Internet TV upstart Veoh (see BW Online, 4/18/06, "Why Veoh is Having a Big Day").

The company, which offers broadcast-quality video over the Internet, is on a roll, having recently raised $12.5 million in funds from Time Warner and other investors. Other backers include Spark Capital, Michael Eisner's Tornante Company, and Shelter Capital Partners. It offers a broad range of programming from politics, technology, and religion, to documentaries and what the company calls "weirdorama."


  The site would work well with MSN Video, which is one of the most popular destinations at MSN. "MSN Video is in high demand among advertisers. Reserving an ad on the homepage must be done months in advance, and certain holidays must be booked a year in advance," says Jeff Lanctot, vice-president of media and client & services at Avenue A/Razorfish.

As Microsoft's business model focuses more and more on content, it may need to bring more expertise in this critical area in-house. That's why it might make sense for the company to acquire or partner with a company that has experience in selecting content and developing the ads and promotions that are wrapped around it.

There are plenty of smaller and medium-size companies that could lend expertise in this area. Media Match Maker, for example, specializes in product placement and sponsorships. The privately held online service in Culver City, Calif., was launched early this year by former Fox marketing executive Betsy Green. And Davie-Brown Entertainment, based in Los Angeles, also focuses on product placements and promotions. Both agencies could help built the value of MSN's online advertising.


  An ad agency could help Microsoft navigate a key change in consumer behavior. People are rapidly evolving beyond the couch potatoes of old, who passively absorbed corporate sales pitches in between segments of TV shows. Instead, they're taking more control over what they watch, though technologies like TiVo (TIVO) and YouTube, and skipping commercials they don't want to see. "Consumers are less willing to view ads that have a negative impact on the viewing experience," says Bainbridge's Marchese.

"What Microsoft sees is that by leveraging technology to serve only relevant ads, they increase the value of every ad shown and decrease total ads that must be viewed by consumers of their content," Marchese says. In this new environment, targeting ads to people who actually want to view them is a critical skill. Microsoft has shown via its acquisition of Massive that it sees the need to bring some of this expertise in-house.

Microsoft also is expected to build out infrastructure for the delivery of its content into the home. It's using the Media Center version of the Windows operating system in an entertainment device that functions as a PC, cable, or satellite-TV box, as well as an MP3 jukebox and digital video recorder for storing and playing hours of video.


  The next step is helping consumers share all that content among various devices in their home. A company like Ruckus Wireless might be a smart play for Microsoft (see BW Online, 2/15/06, "Did Ruckus Pick the Right Brand Name?"). Ruckus' device routes high-quality video throughout a home using a regular Wi-Fi connection.

While that's theoretically possible with a regular Wi-Fi router, Ruckus says it has figured out ways to sidestep the technology's problems of limited range, spotty performance ,and interference from other devices that use wireless spectrum.

When Gates started Microsoft, he probably had little idea that the fledging software giant would become so heavily involved in media. But Microsoft isn't alone in its transition. Apple already has refashioned itself as something of a media company, thanks to the strength of the iPod and iTunes. With so much money on the table, Microsoft can't afford to be left behind.

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