Microsoft's Urge to Merge

Deal or no deal with Yahoo!, the software giant faces pressure to close the gap with Google, and acquisitions are the most likely avenue

A day before reports that Microsoft resumed talks to buy Yahoo!, the head of mergers and acquisitions at Microsoft said the company is still angling for a big fish in the online market and has been ramping up its ability to absorb large targets.

Microsoft's purchases have been getting bigger of late, but Yahoo (YHOO), with a market value of $42 billion and likely a higher price tag, would be the largest deal Microsoft (MSFT) has ever attempted. Reports on May 4 said Microsoft had considered buying Yahoo or striking up another kind of partnership with the Internet company, but that talks had stalled. The companies had last considered a tie-up in 2006. Microsoft declined to comment.

Whatever the outcome of talks with Yahoo, the software maker clearly is willing to spend more on purchases. Microsoft's corporate vice-president of corporate development, Bruce Jaffe, says the company has doubled its average acquisition size, to about $60 million, this fiscal year. During the first three quarters of 2007, Microsoft has spent between $1 billion and $1.5 billion on acquisitions, vs. $649 million in all of 2006.

Getting Up to Speed

And the company has been investing in financial, human resources, and IT systems designed to get newly acquired teams up to speed quicker once inside Microsoft. These new processes and computer systems can track on a daily basis how an acquisition is performing and generate reports for the executive responsible for a deal. "The great acquirers have built these," Jaffe says.

If the opportunity arises, Microsoft is also equipped to fold in a big Internet company, Jaffe says. "There's nothing structurally that's preventing us from doing it," he says. "We just haven't found the right company at the right time." Jaffe declined to comment on specific deals. "We'd love to find a way to accelerate the growth of our business in consumer online," both through acquisitions and in-house development, he says. Trouble is, there aren't that many Web companies with reach. "The sample size isn't that large," he says.

And while Microsoft has been one of the computer industry's most voracious acquirers, snapping up roughly 150 companies since 1990, its track record on integrating deals is spotty. It has excelled at grafting small technology teams onto existing products but has struggled with larger buyouts. That may need to change in a hurry as online software leader Google (GOOG) pulls further ahead.

Gaining a Stronger Foothold Online

"They need to do something bigger, faster," says Brian Roberts, senior managing director at investment bank Evercore Partners (EVR), and Microsoft's former head of M&A, who left the company in December, 2005. "From where they're chasing Google at this point, they can't do it organically. It's beyond throwing bodies at problems. It's bringing in new DNA and new technologies and trying to do more faster. Google is a very formidable, very scary competitor."

Microsoft's acquisition of voice-recognition software company Tellme Networks, which closed on May 3, could be a template for future deals. When the transaction was announced in March, Credit Suisse (CS) analyst Jason Maynard said Microsoft paid more than $1 billion (see, 3/15/07, "Microsoft's Expansive Plans for Tellme"). That's a far cry from the $50 billion or so that Yahoo might fetch, but it points to Microsoft's increased willingness to pull out the stops to get a stronger foothold on the Web.

To close the Google gap, Microsoft may need to either buy an established player that can inject online ad revenue and bolster its brand on the Web or redouble efforts to build Internet products that don't rely on traditional search-engine results served to a browser. "The horse has left the gate and it's at the three-quarter turn," says Lise Buyer, a former executive at Google who helped lead the company through its 2004 initial public offering and is principal of Class V Group, which advises startups on IPOs. "It's certainly too late to start a Skunk Works in the Internet advertising space. You either buy an established player or start a project that tries something different."

Dipping Its Toe In

Tellme falls in the category of established player: It has amassed a database of billions of phone calls that relate callers' vocal utterances to what they actually meant when they use Tellme's directory assistance service or call companies like FedEx (FDX) and American Airlines (AA). The technology also works on IP networks, which could give it applications for Microsoft's Windows operating system and Office applications.

Microsoft needs to acquire product lines that can generate $1 billion or more in yearly sales, says Kevin Harvey, a general partner at Benchmark Capital, who helped sell Tellme to Microsoft. So far though, Microsoft's mostly dipped its toe into the waters of the emerging, consumer-oriented Web. On May 3, it bought ScreenTonic, a French maker of software that serves ads to cell phones for companies, including Coca-Cola (KO), McDonald's (MCD), and Reebok International (ADDYY).

It's the latest in a series of small-potatoes buys over the past two years that also include Onfolio, which lets PC users organize Web research; FolderShare, a service for synchronizing files across computers; and Seadragon Software, which lets users fly through 3D photos on the Web. And the company has reportedly talked with 24/7 Real Media (TFSM).

Moving the Needle on Revenues

Nice-to-haves, but not game-changers. UBS (UBS) analyst Heather Bellini on May 4 reissued a March research report that said: "Microsoft needs to invest in large markets with favorable growth prospects to move the needle" on its projected $51 billion in 2007 revenue. "The online advertising market clearly fits that bill," she said.

The online ad market is growing at a rate of about 20% a year—faster than any of Microsoft's core businesses—and is expected to hit $43 billion by 2009. "Despite this favorable outlook, Microsoft's chance to participate in this growth opportunity appears to be slipping away," Bellini said. But in her e-mail, Bellini noted that a Microsoft-Yahoo merger would face steep challenges, including keeping employees on board and combining the companies' ad-serving software. "We think M&A pricing and timing in the Internet is being driven primarily by competitive pressure and scarcity of assets."

To wit: Ad sales through Microsoft's online services group jumped 23%, to $456 million, during the quarter ended Mar. 31, but that's dwarfed by Google, which posted $3.66 billion in revenue for the March quarter. And Microsoft's 10.1% share of U.S. Web searches in March lags far behind Google's 53.7% share, and 21.8% of searches on Yahoo, according to market research firm Nielsen//NetRatings (NTRT) (see, 4/2/07, "Where Is Microsoft Search?").

"The Gloves Are Off"

The need to bulk up online has become even more acute since Microsoft lost out to Google on the acquisition of banner-ad distribution company DoubleClick on Apr. 13 (see, 4/14/07, "Google's DoubleClick Strategic Move"). Jaffe says Microsoft's failure to snare DoubleClick hasn't changed its plans. "Our strategy's the same after the DoubleClick trade," he says. "I don't think there's one company that will make or break us."

Google's using acquisitions to corner Microsoft in other areas, too. On Apr. 17, it bought presentation-graphics software company Tonic Systems, whose online TonicPoint software can also read and edit Microsoft PowerPoint files. And the company's scattershot approach makes it hard for Microsoft to predict where it will aim next. "Google is creation, at some levels, through chaos," says Buyer. "This isn't about everyone trying to row in the same direction to get there faster."

Other companies, too, are using M&A to put the hurt on Redmond. On Apr. 30, Yahoo said it would buy the 80% of online advertising company Right Media it didn't already own, for about $680 million (see, 5/1/07, "The Promise of Online Display Ads"). And Cisco Systems' (CSCO) $3.2 billion buyout of WebEx Communications on Mar. 15 will pit the company directly against Microsoft in the market for online videoconferencing and collaboration. "The gloves are off," says Charles Giancarlo, Cisco senior vice-president and chief development officer.

Integration Is an Issue

Now, the question hovering over Redmond is whether it can pull off a multibillion-dollar buyout. In an interview, Microsoft chief research and strategy officer Craig Mundie says management has become more "flexible" to consider large acquisitions, as evidenced by its 2004 negotiations to buy German software giant SAP (SAP).

Yet not all of Microsoft's large acquisitions go as planned. The company's Dynamics business applications group, which consists of its $1.1 billion acquisition of Great Plains Software in 2000, and Navision, bought for $1.45 billion in 2002, has struggled with profitability and management changes. Microsoft's $425 million acquisition of WebTV Networks in 1997 never took off, and WebTV technologists are now scattered throughout the company's MSN, Xbox, and IPTV groups. And sales of professional drawing software Visio, which Microsoft bought for $1.3 billion in 1999, fell 22% in February, despite the first new version of the software in several years, according to a Mar. 27 report from Merrill Lynch (MER).

Evercore's Roberts says Microsoft Chairman Bill Gates and CEO Steve Ballmer challenged senior executives at the end of 2004 to get more aggressive on the acquisition front instead of "cleaning up messes" from bad deals.

Leveraging MSN Properties

According to Jaffe, Microsoft plans to pursue deals that can bolster its presence in Web searches for specific areas of expertise, along the lines of the company's Feb. 26 acquisition of Medstory, which lets consumers winnow down searches for online health information. The company also wants to do deals that can help it make money from its MSN properties Hotmail and Windows Messenger, something Microsoft currently doesn't do. "It's more than just what we do on search," he says.

Yet for Microsoft to satisfy investors and position itself for future growth, it may need to soon turn its revved-up M&A engine on that very area.

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